Executive Summary
The Islamic Banking institution is a new and constantly evolving concept. In relation to the Western way of banking, the Islamic Banking system is free of interest. One might wonder what the incentive to lend money would be. Others may not understand what benefits could be had by putting their savings into a bank account. While Muslims do not believe in charging or earning interest, they have developed a very complex alternative that is being implemented all over the eastern world. Started from just an idea, this new way of banking quickly spread through the Muslim countries, and has continued to expand all over Europe and Asia. Although the system is proving to the West that it can work, it is still trying to iron out some of the inefficiencies that it currently has. Once the system is more efficient, it will be better able to provide its members with a stock market that works in the same efficient way as it does here in the West.
Introduction
Facts and Figures
- $230 billion: total assets of Islamic institutions
- 75: number of countries where Islamic institutions operate
- 15%: expected annual growth of Islamic finance in the next five years
- 1975: date of the creation of the first modern Islamic commercial bank, the Dubai Islamic Bank
- DMI Group: largest international Islamic finance group
- Pakistan: first country to Islamicize its financial system (1979).
Islamic Banking, based on the prohibition of interest, is becoming more and more popular through the Middle East. The implementation and continuing existence continues to raise skepticism as to its effectiveness, while its ability to provide needed economic funding remains under the watchful eye of the governments who participate. Many would wonder what the incentive would be to lend money if interest were not to be earned. The concepts of Islamic banking vary immensely from Western ideas. The idea of riba (interest-free) banking is foreign to the West. The differences come from a multitude of areas with the foundation existing in the fact that making money off lent capital is against the Islamic religion. This and many other topics will be discussed in the following essay along with the fundamental principles associated with Islamic Banking.
Historical Development
The idea of creating an Islamic banking program can be traced back to 1946. This is when the ideas formed that there was a need for "commercial banks [without] the evil of interest" (Gafoor, 4.1.1). This is also when the concept of Mudarabha1 (Profit Loss Sharing) was formed. Many theories were developed, and the involvement of numerous institutions and government groups resulted in the establishment of the first interest-free banks. Islamic Banking was established in 1975 with the development of the Islamic Development Bank, an inter-governmental bank, and the Dubai Islamic Bank. They wanted to rid the Islamic economy of riba. The need for the interest-free banks was in direct response to the excess cash that many Muslim’s earned following the oil-price hike of 1973 (Gafoor, A, 5). The banks were established mostly for investing purposes, which could explain their weaknesses in the transaction aspects. The two of these areas need to be addressed separately, and by doing this they would have been better able to conceive a plan that would be more appropriate for their economy.
Implementation
In the ten years following the establishment of the first successful interest-free bank, over 50 other similar banking establishments have developed. Almost all of them are concentrated in Muslim countries with a few extending into Western Europe. For most of the countries, this change was made through private initiatives, while in Iran and Pakistan; it was made by government initiatives and covered all of the banks in the country. The implementation of this type of system was completed quite quickly. For example, in Iran and Pakistan, the initial idea of implementing the interest-free system began in 1981. In January, they took the first steps by starting the Profit Loss Sharing system for new deposits. By 1985 they formally transformed the system to be no-interest. This step only took six months. In July of 1985 banks could no longer accept interest bearing deposits, and all previous deposits were formally under the PLS system (Gafoor, 4.1.2). It is obvious that the change was dramatic yet did not take long to implement.
Basics of Islamic Finance
In general, all interest-free banks agree on the same principles while each individual bank has its own application. Muslims are prohibited by their religion to deal in interest (riba). Therefore, an Islamic Banking system cannot pay any interest to those who deposit their money, nor may they collect from those who borrow money from them. The lender is entitled to the return of his or her capital in full.
All Islamic Banks have three kinds of deposit accounts: current, savings, and investment. In the case of current accounts, the deposit is guaranteed. In terms of savings accounts, they can be dealt with in a number of ways. In some, the banks are allowed to use the depositor’s money but they are guaranteed to get the full amount back from the bank. In others, it is thought of as more of an investment type account. The capital is not guaranteed, but the money is invested in low-risk securities, which could also provide a profit. For an investment account, deposits are accepted for a fixed or unlimited period of time. The investors in these types of cases agree in advance to share with the bank their profit or loss. Their capital is not guaranteed.
Types of Islamic Financing
There are three general ways that these banks acquire assets or financing projects, these will be discussed further in the following sections. The general ways that Islamic financing occurs are investment financing, trade financing, and lending.
Investment Financing
Many banks join another entity to set up a joint venture. This is not unlike the joint venture concept that is practiced in the United States. In this case, it is decided ahead of time how the profits and losses will be shared by the investors. In these types of projects, the parties participate in numerous aspects of the project in all sorts of degrees.2 The bank is also sometimes willing to take a riskier approach through Mudarabha. In this type of case, which will be thoroughly discussed throughout the paper, the bank provides all of the capital while the company provides the labor, management, and expertise. The bank will share in the pre-determined profit, but when the loss occurs the bank is the only one who will bear the risk. The bank also depends on an estimated expected rate of return on projects. This is made in the hopes that the project will have profits high enough to pay the bank their required rate. If the business happens to be even more profitable than estimated, the excess will remain with the client. If the bank underestimated the return, it is the bank that will take a share in their loss (Gafoor, 4.2.2.1). To better understand these terms, Mudarabha and Musharaka, we can take a look at how they relate to financing in the United States. Mudarabha can be looked at much like a loan from a financial institution, such as a commercial bank. In these types of financing, the banking institution plays no direct role in the management of the project or company. Musharaka can be looked at like a venture capitalist, where it is not only the money that is provided, but also other management guidance through the life of the project.
Trade Financing
Islamic banks operate in terms of trade financing in five main ways: mark-ups, leasing, and hire purchase, sell-and-buy-back, and letters of credit. Mark-ups occur when the bank buys a product for the client and in return, they will receive the price for the item along with an agreed upon profit. They also do the typical leasing program, which allows someone to lease a product for an amount of time then purchase the product by paying off the remaining value. Somewhat like the leasing program is the idea of hire purchase where the bank buys a product then hires it to someone who they make the rent payments. At the end of a specified amount of time, the person making the rent payments automatically owns the product. Next is sell-and-buy-back when a person sells the bank a product and then promises to buy it back later for a larger sum of money. Lastly is letters of credit where the bank imports a product using its own money then shares the profits when someone else sells it after the mark-up (Gafoor, 4.2.2.2).
Lending
Banks are also able to bring in business through their lending practices. All loans are connected to a service charge rather than interest payments. This allows them to borrow money while also covering their own expenses. The maximum service charge is often set by the authorities, but usually falls around 4%. The banks are also willing to set aside a certain amount of money that will be lent to borrowers without charging a service fee. They do this to help those who would not be able to pay the 4% service charge on borrowed money (Gafoor, 4.1.2). It must be noted here that this type of banking program is fairly flexible, and willing to work with a wide variety of borrowers regardless of economic positions.
Specific Financing Techniques
There are many types of Islamic financing techniques with very specific requirements in for them to be legal under the Islamic Law. Murabaha, Ijarah, and Istinsna are the main techniques used in Islam.
Murabaha
The first type of financing technique is murabaha4, which literally means cost-plus or mark-up (Ariff, 46-62). Simply put murabaha means sale. There are two types of murabaha the first being an ordinary murabaha sale in which a seller provides a specific commodity to a buyer with a known price, or mark-up, added to it. The buyer knows exactly how much the seller paid for the commodity or how much cost was incurred and exactly how much of a profit the seller will be making on the sale. The second type is murabaha sale connected with a promise. In this type there are three parties involved: the seller, the buyer and the bank acting as an intermediary trader between the buyer and the seller.5 Islamic banks use this form of murabaha. They assume the responsibilities of the commodity by purchasing it from the seller and then reselling the commodities on Murabaha to the one who promised to buy the commodity.
There are certain conditions that must be met in order for a murabaha to be a valid sale.6 The seller must inform the buyer how much cost was incurred and how much profit he will make from the sale. The profit can be determined by mutual consent either by a profit to cost ratio or in a lump sum. Expenses incurred by the seller in acquiring the commodity can be, and usually must be, included in the cost of it but costs that are reoccurring such as salary or utilities of a business are not included in the costs that are incurred. It is very important that both parties in the transaction know the costs associated with the commodity in order to agree upon a profit. A murabaha sale is only valid if the exact costs can be ascertained.
It is important to note that murabaha does not take the word interest and replace it with mark-up also murabaha is an asset-based form of financing and there are several reason why this is true. There are strict regulations that must be followed in order for murabaha to be a legal form of financing. There are some basic features of murabaha financing. Murabaha is not a loan, it is an actual sale of a commodity for a price with an agreed upon profit. If no actual sale of commodity exists than the transaction is not murabaha and is not a legal financing technique. A commodity in this sense, can be consumable or physical. Murabaha is only an asset based form of financing since murabaha can only be used when a client need funds to purchase commodities. If the client requires the funds for other purposes murabaha cannot be used as the transaction mode since no real sale of commodities existed. Another key point is that the seller must actually own the commodity before it is sold to the client. Not only must the seller own the commodity for a short period but also that period must be long enough so that the seller will bear some sort of risk for that period of time. For example, if a person purchased an acre of land and wanted to sell it on murabaha, he would have to have the land in his possession long enough so as to run the risk of any losses that could be incurred from inclement weather or other disasters that could happen to the land. He could not sell it, in this case, a day after he bought the land because the risk that he will incur a loss to land in one day is very low. This is the only feature that distinguishes murabaha from an interest-based transaction.
Ijarah
The second form of Islamic financing is ijarah literally meaning “to give something on rent”, according to www.islamiq.com. In terms of financing it is equivalent to the English term leasing. The rules of leasing are very much like the rules of sale because something of value is being transferred. The rules of leasing are also very equivalent to the rules of leasing in the United States.
There are some basic rules of leasing including that the subject of the lease must have valuable use. Anything that cannot be used without consuming cannot be leased since the actual entity being leased must remain in the possession of the lessor. Therefore gasoline, consumables and anything else of this nature cannot be leased. Rent is determined by an agreement between the lessee and the lessor. It is predetermined, agreed upon amount. Any rent charged on an invalid lease will be considered interest and thus will not be a valid lease. All liabilities rising from the ownership of the property (taxes) shall be borne by the lessor while all liabilities rising from the use of the property (heating, water bills, etc.) shall be borne by the lessee. Any loss or destruction done to the asset during the lease period is borne by the lessor. The lease period as well as the use of the asset must be clearly defined.
Istisna
Istisna is a third form of Islamic financing. It is a form of sale where the transaction of buying and selling a commodity happens before the commodity comes into existence. A manufacturer agrees to manufacture a specific commodity for a specific purchaser by a specific, agreed upon date. The price must be a fixed price that is agreed upon by the manufacturer and the purchaser. Also, the specifications of the commodity must be agreed upon before production begins.
“One of the main uses of istisna as financing is the house-purchasing sector. If a client has his or her own land and seeks financing for the construction of a house, the financer may undertake the 'contract' to construct the house on the basis of istisna. If the client has no land and wishes to also buy land, the financer may undertake to provide him a constructed house on a specified piece of land.” (www.islamiq.com)
It is not necessary for the financer to actually construct the house. A third-party istisna may be formed. The cost of the contract is fixed into the cost in calculating of the istisna. The financer is responsible for all specifications of the house or project and if there are any variations the financer is responsible for making the corrections in accordance with the istisna contract. As long as the parties are in agreement, payments may be fixed in whatever manner that the parties wish. Payments may in one lump sum or they may be made in installments. If the financer wishes, he or she may keep the title deeds for the house or property until the final payments are made as security for the payments.
Sharia Issues
A systematic understanding of stocks from Islamic perspective is necessary, but first one must look at the Sharia before trying to understand the mechanics of legal actions. Sharia is defined as the “the path or road leading to the water”, a way to the very source of life (Rosley, 32). It is God who shows the way man should conduct the spiritual, mental and physical aspects of his life. By conducting ones life in this manner one will realize his will. At its most basic level, the Sharia has two basic principles. The first is the removal of hardship (ra'f al-haraj) and second, the prevention of harm (daf’al-darar). With this in mind it is important to recognize efforts to introduce the Sharia screening on stock and portfolios so that ideals are always preserved and protected. Since the Sharia dictates the way of Muslim life there are many issues to take into account when dealing with Islamic finance (de Belder, 40-44). Because the Sharia is a type of law followed by the Muslim’s, there are also cases where the law of the land precedes over the people.
Most issues and concerns concerning Sharia law, differ from country to country. First and foremost there is no binding precedent in court cases. If a matter comes before the Sharia court there is no definite outcome since there is no standing precedent to look upon for answers as there is in the Western culture that most of us are accustomed to. (For example, someone who is going to court because they stole a loaf of bread does not know for sure what will happen to them as far as sentencing is concerned. He cannot look upon or reference previous cases of bread stealing to estimate what kind of sentence he will receive. Each case stands alone.) In commercial matters they may go to the Commercial or Civil Courts but there is still no standing precedent and Sharia law7will normally rule.
Another important issue regarding Sharia is the interest factor. Interest is prohibited under Sharia, so investors must use other modes of financing that do not earn interest. Lending requirements under Sharia require that profits come from returns generated by the ownership of assets put to real economic use, not from a conventional interest rate. Real economic use means that the money must actually be used in order to see the return, interest may not just be charged in order to earn a profit. In the case of a bank, it cannot just lend money to someone and charge him or her an interest rate. The money must be used to build something or the bank will maintain ownership of a construction project until it is finished. Then the bank may take part in the profits of the business, and that is how the bank would make a profit. In some cases interest is allowed but only under very strict guidelines such as a stated, agreed upon rate.
Leases are allowed under Sharia law and they offer many positive characteristics, which make them an attractive investment vehicle. The security of assets is very attractive, especially for moveable assets. Leasing also allows investors to invest in long-term assets and lastly lease deals can very flexible in their structure as long as the key legal requirements are met. Islamic leasing is also attractive because most investors don’t finance above 85% of the costs of a project, while Islamic investors will finance up to 100% of the costs. (Carter, 23-25) The Islamic leasing sector is less volatile than other sectors. Islamic investors are less likely to react to negative events.
Basic Anatomy
Savings Accounts
Savings accounts in Islam are operated on an al-wadiah basis, meaning a safekeeping basis. The bank may pay its depositors a positive return periodically based on profits of the bank. These payments are legal in Islam since the payments are not predetermined and they are not a condition of lending. The depositors are allowed to withdraw money at anytime they please. Investment accounts are based on the mudarabha, or profit-sharing, principle. The deposits are term deposits, which means that there is a set date to maturity, and cannot be withdrawn before maturity. The rate of return can be positive or negative but in most cases they are positive and comparable to rates the conventional banks offer on their term deposits.
Capital Owners
Capital owners take on a specific role in Islamic financing. Islam does not deny that capital should be rewarded. It does allow the owners of capital a share in a surplus that is uncertain. Islamic investors do not however, have a right to demand a fixed rate of return. The owner of capital, rabbul-mal, may invest by allowing someone with ideas and expertise to use the capital for productive purposes and the rabbul-mal may share in the profits. If there are any losses they will be borne entirely by the rabbul-mal8.
Equity Participation
Equity participation is referred to as musharakah in Islam and it means literally to share. All partners in a venture share the profit or the loss based on some sort of predetermined equity ratio. Musharakah (equity participation) and mudarabha (profit sharing) are considered to be the twin pillars of Islamic finance. “The musharakah principle is involved in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership.” (Ariff 1988) Islamic banks act as borrowers which manage funds of depositors to generate profits subject to rules outlined by the mudaraba. The bank may use the depositor’s funds on a profit sharing basis in addition to other lawful modes of financing. The bank acts as the mudarib9 and the rabbul-mal.
Bai’salam
Islamic banks also use pre-paid goods, bai’salam, as a means to finance production. The delivery takes place at a future date from the time of the contract and it is at this time of the contract the price is paid. Normally, no sale can be take place unless the goods are in existence at the time of the bargain. Since, in bai’salam the date of delivery is defined and the goods are defined the sale can take place and be exception to this rule. Payment must be made in advance in order for this to be considered a legal sale. This is done because it allows the entrepreneur to sell his output to the bank at a price determined in advance. Banks use this form of financing normally in the agricultural market. They pay farmers in advance for a share of their crop, which the bank in turn will sell on the market. In the entrepreneurial sense, bai’salam is used when a manufacturer needs capital to manufacture a good. In return for providing the capital, the entrepreneur will receive a reduced price on the goods being produced if he or she wishes to purchase them.
As far as an Islamic bank’s investment portfolio, it has the options of the mudarabha10 and musharakah11 modes of investment, but most banks prefer less risky modes of investment. The most commonly used form of financing is the murabaha. A chart at the left, shows ABC Islamic Bank’s total assets for 2000 shows that murabaha is preferred form of investment by Islamic banking institutions as well as for personal and entrepreneurial investing. Murabaha is used when “the bank finances the purchase of a good or asset by buying it on behalf of its client and adding a mark-up before re-selling it to the client on a cost-plus basis. (Ariff, 46-62). The most important part of a murabaha transaction to make it legitimate according to Islamic law is the fact that the bank acquires the asset for a short period of time in which it assumes the risk of the asset. Thus by assuming the risk between purchase and resale, the transaction is considered to be interest free.
Islamic Stock Market
A stock market based strictly on Islamic principles is still in the early stages of its evolution. This development based on Islamic principles is part of an on going process to institute a financial system in the Muslim world. These principles are based on the interpretations of Sharia12 which were explained earlier.
The first step in establishing an Islamic stock market would be to rid the system of riba, or interest. Although riba was explained breifly earlier in this text, it needs to be elaborated on in order to understand it in the context of the Islamic Stock market. Riba has a much broader definition than simply referring to interest. It encompasses all forms of exploitation and excessive charges in business dealings. The stock market itself could be perceived as riba. In the sense that riba means an exploitation of business dealings. An example of this problem would be unequal information among investors or use of any information to take advantage of another investor.
The social wellness function for the Islamic stock market thus continues on to be a knowledge-based encapsulation of a wide range of socio-economic activities that establish cause-effect interrelationships with the stock market as an important kind of ethicized market. This market also plays a significant role in socio-economic development.
“It is also important to note here, that while the Islamic political economy treats the stock market as an ethicizing institution of man and nature for purposes of socio-economic sustainability, this treatment becomes a normative issue in focus. The Shari'ah policies of the transformation process of an Islamic stock market based on complementarity and preferences interactions as knowledge-based processes are then normative issues which are subsequently carried towards quantitative applications. They are thereafter reiterated in the circular causation and continuity model. On the other hand, models of stock market behaviour in manistream economic theory are positivistic models of hedonic competition between all kinds of ventures. They have no moral compunction to serve. Such models assume that competition (taken in the sense of economic rationality) is the Hobbesian character of human beings that cannot be and need not be changed by policies that normatively delve in the epistemological questions involving ethical purpose (Financial Institutions, http).”
Market Efficiency
Efficiency is a difficult concept to define in the context of stock markets. Efficiency depends on whether you are referring to primary or secondary market functions. At the primary market level it would be referred to as the optimal allocation of resources in the primary market, allocation efficiency. In the secondary level it would be considered a market in which the lowest possible transactions prices prevail, operational efficiency. These premises also imply a well-developed trading system that is fast and has accurate process transactions. While these concepts appear relevant from an Islamic standpoint, it is possible that a broader view of efficiency may also be appropriate (Naughton, 5).
A broader view of efficiency in the market is similar to the concept of social efficiency. This notions states that both financial markets and stock markets should be efficient in the sense that they support social justice, fairness and the well being of the society as a whole. This is not a strong feature in Western markets and it could be argued that these markets actually create social inefficiency by encouraging unequal distribution of wealth. In addition to this speculation, financial markets provide opportunities for dishonest activities such as insider trading. These dishonest activities could have an adverse effect on moral standards and business ethics (Naughton, 6).
Securities
Modern financial institutions, such as security and derivatives markets, and instruments such as bonds, futures, swaps, shares and options create problems in an Islamic market. The reasons come from an unclear Sharia instruction for their use. Although stock markets are permitted in Muslim countries, it does not mean the trading practices of the markets are in accordance with the Sharia. Interest-based banks are permitted in most of the Muslim, yet interest is forbidden in Islam. The approach used to examine the acceptability of anything is to consider if it fits within the Sharia instruction. The securities that are used most commonly are common stocks and bonds. Less common but still used are preferred stock, futures and options (Naughton, 7).
Common Stock
In an Islamic context we will refer to common stock as Mudarabha13. Common stock represents a claim to ownership on a company and these stockholders are the owners of the business. This ownership entitles them to share in the rewards or profits of the company. Other rights as a stockholder include the right to vote at stockholder meetings and elect the directors of the firm. On the other hand, stockholders bear the residual risk that third party claims must be met first before the stockholders receive any return on capital.
The scholars and economists of Islam concur that these features make the buying of common stock acceptable. The Council of the Islamic Fight Academy (CIFA) has also approved these common stocks as an investment tool. The CIFA is an international body of Muslim jurists sponsored by the 46 nation Organization of Islamic Conference (Naughton, 8). This council is a respected advisory board that gives direction to the Muslim community internationally. A strong feature of modern Islamic banking theories is that common stocks closely adhere to the profit and loss sharing principles. With the CIFA and banking theories it is difficult to fault common stock as an Islamic instrument.
Debt Securities
Debt securities, such as bonds, present problems to the Islamic investors. A traditional Western style corporate bond is likely to fail any test of acceptability because it is interest based, paying a fixed amount over a specific period of time. In the event of default, penalties are imposed, thus allowing bondholders to take action to recover the outstanding interests and principal. Such penalties are deemed un-Islamic and that is the reason for the prohibition of these bonds. However, Islamic institutions will need varying amounts of short, medium and long-term capital. In order to do this Islamic banks and financial institutions provide financing through various financial contracts. These contracts fall into four categories, and all have variations. The most progressive, from a Western point of view, is profit and loss sharing contracts in which banks are effectively limited term equity investors in the borrowing realm. Examples of these contracts are Mudarabha, mentioned above, and Musharika. Musharika are contracts based on the transactions, where a bank buys assets required by customers and sells them to the customer at a profit with deferred payment. A third type of contract is the Al-Ijarah, is a Western style lease, and is the most commonly used. The final type of contract is the Qard-ul-Hasan. A Qard-ul-Hasan loan is free of any rate of return, although the recipient may wish to compensate the provider with a return in excess of the original borrowing. This is a benevolent loan that is increasing being used to solve problems where there is no other suitable Islamic financing contract (Naughton, 9).
The solution to some of the Islamic debt security issues is likely to be that of transforming traditional interest bearing bonds into transaction-based bonds. Equity based debt contracts are unlikely to provide a balance of financing required by modern businesses or to meet portfolio requirements of investors. Transaction based contracts like the Murabaha, a mark-up or cost- plus, can be used to create debt instruments tied to a particular transaction. An example would be the purchase of an asset by a firm or a series of transactions packaged together. Subscribers to a bond issue would initially buy the asset(s), resell to the borrower at a price higher than the original cost and receive payment for the sale over a stipulated time period in a comparable manner to a conventional bond servicing schedule.
Such forms of debt and bonds raise questions of whether or not it is a fixed return. The resale of an asset, at a price greater than original cost, represents a fixed return to the provider of the financing. Current practices of Islamic banking state the return will be greater the longer the period of repayment. This has been challenged often because of its similarities to riba, no interest, or interest. The consensus of the issue is that these contracts are acceptable whether return is fixed or whether payment increases over time. A straight loan made to the borrower not tied to any asset and receives a return is not acceptable. This is true even if the proceeds of the loan are used to buy a specific asset (Naughton, 10).
Preferred Stock
Preferred Stock is not a significant form of finance in the Islamic market today. However, it is sometimes used. Preferred stock holders in the Islamic arena forego voting rights and participation in management and as a consequence they do rank above common stock holders. But their dividend is a fixed rate, not a share of profits. This fixed return is based on the original investment. Preferred stock is similar to traditional debt financing, or bonds. The main difference is simply the terms used; the return to preferred stockholders is dividend while the return to bondholders is called interest. It has been considered that the restructuring of preferred stock to give the stockholders more equity like features is likely to be acceptable, provided the return is not fixed. Another solution is to structure preferred stock as transaction specific, similar to what has been proposed for bonds. The result in either case is a hybrid security that leads to unclear benefits (Naughton, 11).
Stock Brokering Firms
A traditional firm structure consists of member firms that act as brokers for investors, market makers and traders on their own account. These member firms typically dictate the controlling body or council of the exchange. The controlling body of the exchange will act in the role of a self-regulator in tandem with some form of regulating body that oversees the operation of the market. Membership of the stock exchange is usually restricted and new firms have to either buy an existing seat or apply in accordance with the strict entry requirements (Naughton, 12).
Such a structure seems reasonable for an Islamic stock exchange, as long as the rules for membership do not restrict competition or adversely effect investors. The ideal member will be an Islamic securities business that acts in a way that its affairs are in accordance with Islamic requirements. This will include the absence of riba, interest, in its financial dealing and avoidance of speculation and other unacceptable activities. The next questions that need to be asked is whether Muslims should be allowed to do business or even interact with institutions and banks that are interest based and if non-Muslims should be allowed to do business in an interest-free stock market. These issues demonstrate the many institutional problems that need to be confronted before the progress of the development of a fully developed Islamic market.
Speculation
Speculation is an important issue that needs to be addressed when planning an Islamic stock exchange. Speculation has many forms, but underlying the practice is the fact that speculators are not concerned with the security or commodity that they are trading, but with desire to make a quick buck from buying and selling. Arbitrage is another type of speculation that needs to be looked into. It is clear that these practices are unacceptable because of their association with gambling and excessive risk taking. This undermines the orderly functioning of the stock market while the profits of speculators are accomplished at the loss of another investor. Any potential benefits of speculation are not considered to outweigh the negative aspects (Naughton, 13).
Problems with Islamic Financing
There are four main areas where Islamic banks find it difficult to finance with their profit and loss sharing system. First is participating in long term low yield projects, second is financing small businesses, next is granting non-participating loans to business already running and finally financing government borrowing.
Term Structure of Investments
The table below shows the term structure of investment for 20 Islamic banks in 1998. This graph shows that less than 10% of the total assets go into medium and long-term investments.
Low Yield Projects
This is a very inadequate situation for these banks. The main reason is the need to participate on a profit and loss sharing basis, which involves time consuming complicated assessment procedures and negotiations, requiring expertise and experience. The banks do not seem to have a system developed and therefor choose not to participate. Banks choose not to participate because there are no commonly accepted criteria for the different project evaluations based on a profit and loss sharing system. Each individual case has to be treated separately with the utmost care and has to be assessed in negotiated on it own accord. Other reasons why banks are adverse to doing these agreements are because such investments tie up capital for very long periods of time, which is unlike conventional banking where the capital is recovered in a regular manner from the beginning. The final reason is that the longer the maturity of the project the longer it takes to realize the returns and the banks therefore can not pay a return to their depositors as fast as conventional banks can. With all these reasons it is no wonder why banks are opposed to this kind of investment.
Small Scale Businesses
Small-scale businesses form a major part of the Islamic countries economic sector. Even though these small businesses comprise a large portion of the bank’s clientele, it is hard to provide them with the needed financing under a profit and loss sharing system, even though there is abundant liquidity in the banks. The main problem lies in the comprehensive criteria that needs to be followed in order to grant loans while being able to monitor their use. Small-scale enterprises have encountered greater difficulties in obtaining financing then their large-scale counterparts in these Islamic countries. Many of these small companies, who in the past were able to obtain interest-based financing on the basis of collateral, are now finding it difficult to raise funds for their operations.
Running Businesses
Running businesses often need short-term capital, working capital and ready cash for miscellaneous purchases or various expenses. Unfortunately this important aspect of running a business has not been given much thought in the profit and loss sharing system. Even if there is complete trust and exchange of information between the bank and the business, it is almost impossible or too expensive to estimate this portion of such short-term financing on the return of a given business. Frequently clients need to have quick access to capital for the immediate needs to prevent likely delays in a project’s schedule. According to regulations, it is not feasible to bridge the finance requirements and any financial assistance must be made on the basis of the project’s appraisal to determine type, terms and conditions of the system of financing. The magnitude of the damage caused by the inability to provide financing to this sector will become evident if it is not realized that these running businesses are the foundation of Islamic countries economic survival (Gafoor, 7).
Financial Government Borrowing
In every country the government’s need for credit, both long-term and short-term, accounts for a major component of demand. These loans differ from those to business because these borrowings are not always used for investment purposes, or for investment productive enterprises. Even when invested in productive enterprises they are usually of a lower yield and longer-term type. This only multiplies the difficulties in estimating a rate of return on these loans if they are given (Gafoor, 7).
Conclusion
The Islamic Banking system is still very new. Its impact, though, has been dramatic. Since its implementation, it is the only system in two major Muslim countries. It can be noted that it has been successful in a number of ways yet has its downfalls especially in terms of the finance area. We feel that with a few minor changes, the system will be able to work very efficiently and effectively. While the idea of interest-free banking may be taboo for Westerners, it fits in well with the religious beliefs held by these Islamic countries. In sum, the story of Islamic finance is a vastly complicated one, and cannot be captured without a full understanding of religion and finance, but also of history, politics, economics, business and culture.
Glossary
Al-Ijarah- a Western style lease, and is the most commonly used.
Al-wadiah: safe-keeping
Bai’salam: pre-paid goods
Dafal-dara- The prevention of harm
Ijarah: to give something to rent; lease
Istisna: a form of sale in which a commodity is transacted before it comes into existence
Mudarabha: profit sharing (one investor). One party provides capital, the other party brings work or effort
Mudarib: borrower
Murabaha: mark-up; cost plus
Musharakah: to share; equity participation (many investors) in numerous aspects of the project.
Musharika- contracts based on the transactions, where a bank buys assets required by customers and sells them to the customer at a profit with deferred payment
Qard-ul-Hasan- a benevolent loan that is increasing being used to solve problems where there is no other suitable Islamic financing contract
Ra’f al-haraj- The removal of hardship
Rabbul-mal: owner of capital
Riba- interest-free
Sharia- Taken from the Sharia law, it is the law of Islam, based upon the Koran. Sharia is more than just a law, it is the totality of religious, political, social, domestic, and private life for the Muslim Community.
References
Ariff, Mohamed. “Islamic Banking.” Asian-Pacific Economic Literature, Sept. 1998, 2 (2): 46- 62.
Carter, Phil. “Plenty of Interest.” Asset Finance International Nov. 2001: 23-25.
De Belder, Richard and Chris Ruder. “Middle East: An overview of project finance and Islamic Finance.” International Financial Law Review July 1999: 40-44.
Gafoor, Abdul. “Islamic Banking and Finance: Another Approach.” Sept. 1999, Toronto Canada.
Gafoor, Abdul. “Islamic Banking” Interest-Free Islamic Banking Sept. 1995. Chapter 4.
Naughton, Shahnaz. “Religion, ethics and stock trading: The case of an Islamic equities market.” Journal of Business Ethics Jan. 2000: 1-159.
Rosly, Suiful Azhar. “Investing Now For the Life In the Here After.” New Straights Times Press. Feb. 2002. 3-35.
1 This is a cost plus profit financing transaction used primarily for trade finance.
2 Also referred to as Musharakah: equity participation.
4 murabaha means cost-plus or mark-up
5 www.barakaonline.com.
6 www.islamiq.com/knowledgecenter
7 Sharia law: the law of Islam, based upon the Koran; Sharia is more than just law, it is the totality of religious, political, social, domestic and private life for the Muslim community
8 rabbul-mal: owner of capital
9 mudarib: borrower
10 mudarabha: profit sharing (one investor)
11 musharakah: to share; equity participation (many investors)
12 Sharia: the name given to the sources of the sacred law of Islam, governing all aspects of one’s life; also the law of Islam, based upon the Koran; Sharia is more than just law, it is the totality of religious, political, social, domestic and private life for the Muslim community
13 mudarabha: profit loss sharing
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