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Evolution
| Rationale
| Anatomy
| Literature:
Theory
Literature:
Practice | Conclusion
| Glossary
Appendix: Islamic Financial Institutions | References
Anatomy
As mentioned
earlier, Islam does not deny that capital, as a
factor of production, deserves to be rewarded. Islam
allows the owners of capital a share in a surplus
which is uncertain. To put it differently, investors
in the Islamic order have no right to demand a fixed
rate of return. No one is entitled to any addition
to the principal sum if he does not share in the
risks involved. The owner of capital (rabbul-mal)
may 'invest' by allowing an entrepreneur with ideas
and expertise to use the capital for productive
purposes and he may share the profits, if any, with
the entrepreneur borrower (mudarib); losses,
if any, however, will be borne wholly by the rabbulmal.
This mode of financing, termed mudaraba in the
Islamic literature, was in practice even in the pre
Qur'anic days and, according to jurists, it was
approved by the Prophet.
Another
legitimate mode of financing recognized in Islam is
one based on equity participation (musharaka);
in which the partners use their capital jointly to
generate a surplus. Profits or losses will be shared
between the partners according to some agreed
formula depending on the equity ratio.
Mudaraba
and musharaka constitute,
at least in principle if not in practice, the twin
pillars of Islamic banking. The musharaka
principle is invoked in the equity structure of
Islamic banks and is similar to the modern concepts
of partnership and joint stock ownership. In so far
as the depositors are concerned, an Islamic bank
acts as a mudarib which manages the funds of
the depositors to generate profits subject to the
rules of mudaraba as outlined above. The bank
may in turn use the depositors' funds on a mudaraba
basis in addition to other lawful modes of
financing. In other words, the bank operates a
two-tier mudaraba system in which it acts
both as the mudarib on the saving side of the
equation and as the rabbulmal on the
investment portfolio side. The bank may also enter
into musharaka contracts with the users of
the funds, sharing profits and losses, as mentioned
above.
At the
deposit end of the scale, Islamic banks normally
operate three broad categories of account, mainly
current, savings, and investment accounts. The
current account, as in the case of conventional
banks, gives no return to the depositors. It is
essentially a safekeeping (alwadiah)
arrangement between the depositors and the bank,
which allows the depositors to withdraw their money
at any time and permits the bank to use the
depositors' money. As in the case of conventional
banks, cheque books are issued to the current ac
count deposit holders and the Islamic banks provide
the broad range of payment facilities clearing
mechanisms, bank drafts, bills of exchange,
travellers cheques, etc. (but not yet, it seems,
credit cards or bank cards). More often than not, no
service charges are made by the banks in this
regard.
The savings
account is also operated on an al-wadiah
basis, but the bank may at its absolute discretion
pay the depositors a positive return
periodically, depending on its own profitability.
Such payment is considered lawful in Islam since it
is not a condition for lending by the depositors to
the bank, nor is it predetermined. The savings
account holders are issued with savings books and
are allowed to withdraw their money as and when they
please.
The
investment account is based on the mudaraba
principle, and the deposits are term deposits which
cannot be withdrawn before maturity. The
profit-sharing ratio varies from bank to bank and
from time to time depending
on supply and demand conditions (4)
. In theory, the rate of return could be positive or
negative, but in practice the returns have always
been positive and quite comparable to rates
conventional banks offer on their term deposits (5)
.
At the
investment portfolio end of the scale, Islamic banks
employ a variety of instruments. The mudaraba
and musharaka modes, referred to earlier, are
supposedly the main conduits for the outflow of
funds from the banks. In practice, however, Islamic
banks have shown a strong preference for other modes
which are less risky. The most commonly used mode of
financing seems to be the 'mark-up' device which is
termed murabaha. In a murabaha
transaction, the bank finances the purchase of a
good or asset by buying it on behalf of its client
and adding a mark-up before reselling it to the
client on a 'cost-plus' basis. It may appear at
first glance that the mark-up is just another term
for interest as charged by conventional banks,
interest thus being admitted through the back door.
What makes the murabaha transaction
Islamically legitimate is that the bank first
acquires the asset and in the process it assumes
certain risks between purchase and resale. The bank
takes responsibility for the good before it is
safely delivered to the client. The services
rendered by the Islamic bank are therefore regarded
as quite different from those of a conventional bank
which simply lends money to the client to buy the
good.
Islamic banks
have also been resorting to purchase and resale of
properties on a deferred payment basis, which is
termed bai' muajjal. It is considered lawful
in fiqh (jurisprudence) to charge a higher price for
a good if payments are to be made at a later date.
According to fiqh, this does not amount to
charging interest, since it is not a lending
transaction but a trading one.
Leasing or ijara
is also frequently practised by Islamic banks. Under
this mode, the banks would buy the equipment or
machinery and lease it out to their clients who may
opt to buy the items eventually, in which case the
monthly payments will consist of two components,
i.e., rental for the use of the equipment and
instalment towards the purchase price.
Reference
must also be made to pre-paid purchase of goods,
which is termed bai'salam, as a means used by
Islamic banks to finance production. Here the price
is paid at the time of the contract but the delivery
would take place at a future date. This mode enables
an entrepreneur to sell his output to the bank at a
price determined in advance. Islamic banks, in
keeping with modern times, have extended this
facility to manufactures as well.
It is clear
from the above sketch that Islamic banking goes
beyond the pure financing activities of conventional
banks. Islamic banks engage in equity financing and
trade financing. By its very nature, Islamic banking
is a risky business compared with conventional
banking, for risk-sharing forms the very basis of
all Islamic financial transactions. To minimize
risks, however, Islamic banks have taken pains to
distribute the eggs over many baskets and have
established reserve funds out of past profits which
they can fall back on in the event of any major
loss.
Courtesy
of Mohamed Ariff, University of Malaya
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