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Islamic Banking:A last Ditch to Save Capitalism

Published in: New Horizon (London), February 2004Iraj Toutounchian

Professor of Economics

The prevalence of stagnation in today’s capitalistic world is

unprecedented; a capitalistic world confronted with complex economicissues, which were not so acute in the past. Businesscycles, which were played down in the past, no longer can betreated as such. The intensity of business cycles has reached suchdegrees, within the last couple of decades that advancedcapitalistic regimes have to encounter their overriding existence. This is especially true in a world in which communications haveexpanded enormously as a result of which countries, willingly ornot, have come closer to one another for purposes of economicrelations.Once it was offered, as a claim, to envisage capitalisticeconomy as being self-regulating and self-correcting. The intensityand frequency of economic fluctuations have made even the mostardent of economists to withdraw such a claim. The catastrophehas reached points that if one would fail to see the impact of collapse of the capitalistic system as greater than that exerted bywar, he would succeed in comparing its unpleasant consequencesto those created by warfare. War destroys people and facilities.1But the great collapse, which is likely to occur in near future, willswamp living human beings. Unemployment, poverty, disease,and hunger are not predetermined events; man is not doomed to

accept them as inevitable.Mankind, through the hands of colonialists and strongmenof the capitalistic world has brought about the perilous presentsituation. The greedy and selfish consumption in major advancedindustrial nations, which had been severely and ever-increasinglydisturbing the ecological balance, has culminated catastrophicallyin new heights now imposing a massive threat to all mankind, athreat whose magnitude could have never been imagined by greatarchitects of the Scientific Revolution. The real danger lies in thefact that potentiality of this catastrophe is being played down bysome highly influential executive offices, despite the scientific

community’s repeated warnings, in order to perpetuateirresponsible exploitation of natural and human resources in acapitalistic mode, which secures the benefit of a few over theplanet’s population. The unjustified and unresponsive acts,disregarding good purposes of humanity, committed by the worldcapitalism, particularly since World War II, has disgusted thepublic, creating critical reactions of many kinds, each expressingdeep dissatisfaction concerning the status quo, and the worldgovernance. A casual glance through the history of contemporarysocial thought would reveal a mass of evidence supporting the

point just put forward. We resist the temptation to offer a view on2the social dimension of such dissatisfaction here, in order to makeroom for economics.Unites States of America represents the prototype of a pure

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capitalistic country, and no foreign force as yet has been able toalter its sheer capitalistic course. The immensity of size, power,and the economic complexity of the USA, is unique. It follows,naturally, that its problems do not conform to those of othernations. Thus US economy has to be analyzed as a separatecategory. This “separate” treatment does not mean that the otheradvanced industrial nations are immune to perils that America is

doomed to face. Here, while withholding approval of pointsexpressed by the socialists or the Marxists, we quote a sentencefrom Joseph A. Schumpeter:Marx was wrong in his diagnosis of the manner in which

capitalist society would break down; he was not wrong in theprediction that it would break down eventually. The advanced industrial nations have many characteristicsin common, and all of them will face, sooner or later, the loomingthreat America is destined to experience. Nevertheless, theuniqueness of the American economy requires us to point to direrealities concerning this nation. Obviously the act of pointing tothe USA comprises a general warning of interest to all advancedcapitalist industrial nations. What follows is partially taken fromthe recent report of the Monthly Review.3 The economic theorists and experts discuss endlesslyAmerica’s federal budget deficit, its negative current accountbalance, lack of investment, and the breaking of financial bubble. These theorists fail to realize the possibility that these are merelysymptoms of recession. The prevailing view regards capitalisteconomy as naturally tending toward abundant investment,striking economic growth and wealth, thus the authenticity of the

view that the capitalist economy intrinsically tends towardrecession, is disregarded. The theorists may admit that growthrate of the US economy has been falling since 1960’s, yet theyattribute this decreasing process to state’s bad policies not as areflection of a general process of modern capital accumulation.A more rational treatment of the present situation dependson admitting the view regarding capitalist economy as tendingtowards recession as a natural event. What created the rapidgrowth of the 1950’s-60’s, were historical events like people’ssaving during the World War II, the second wave of automobilization of the US economy (which included steel, glass,

tire, construction industries, and the inter-state freeway network).Added to these were the economic stimuli created by two regionalwars in Asia, and the extraordinary increase of sales organizationrelated to modern techniques of marketing. Most of these factorshave either completely vanished ( as people’s saving during WorldWar II) or have reached the point of stability where they can nolonger be considered as major stimulants for economic growth.4During the 1980’s the main economic stimulant came fromthe expansion of financial superstructure of the US economy. Thisexpansion took place particularly in recent years as regards

electronics and computer industries and that of the internet. These factors, too, have weakened following the breaking of thestock market’s bubble, and decrease of investment in theelectronics and computer industries.

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The unemployment statistics is indicative of theseriousness of the danger poised by it. The number of employmenthas reached its lowest since twenty years ago. According to areport by the New York Times of February 6, 2003, since the crisiscommenced in March 2001, the US economy has lost more thantwenty million job opportunities. Most individuals, confrontedwith the prospect of prolonged unemployment and the glimmer

chance of reemployment, are disappointed and thus have stoppedlooking actively for jobs. Hence, the official statistics does notinclude these people, and therefore the unemployment statistics isan underestimation of the real jobless. To obtain the official figureof the unemployed their number is divided by sum of bothemployed and unemployed individuals, and the result is stated inpercentage. According to such a calculation, the officialunemployment statistics, for January of 2003 was over 6.5%(disregarding seasonal factors). But if we consider the number of individuals who have recently left--per official definition of--thelabor force, and add the number of individuals working part-timeyet seeking full-time work, the real dimension of plight of 5unemployment will surface. Considering these individuals, theunemployment figure for January of 2003 (disregarding seasonalfactors) has been 11%.It is crucial to note that according to the New York Times,the Federal Reserve Board has lowered the interest rate twelvetimes within last two years, decreasing interest on the inter-bankloans to its lowest; to 1.25%, inside of last forty years. In spite of these efforts, the Federal Reserve has not been able to motivateinvestment volume. What determines investment volume in the

new output capacity is the prospect of gaining investment profit inthe future, viz., when the new output capacity would reachexploitation point. If due to limits of the market, or any otherreasons, little were expected of the future profit to be gained frominvestment, then new investments are simply not made. The recent events must have persuaded the westerneconomists (both, Keynesians and monetarists) that despite theirviews, investment is not a function of interest rate, but thereshould be an effort made to search for another factor, a factor thatis responsive in normal, as well as, in risk conditions. This pointdirects us towards interest-free, Islamic banking, to substitute

profit rate with rate of interest. In addition, in such a system,attention is paid simultaneously to both; the supply side, anddemand side economy. These two points, taken together,constitute a special feature of Islamic banking, a feature lackingin capitalist economy. We should bear in mind that all business6cycles are rooted in money and are somehow related to interest,which is the result of speculation. Two main subjects are discussed here. First is thateconomic system should deal with two principle categories, viz., onthe one hand, the issue of justice (equity), and on the other, the

issue of efficiency. Between these two issues lies their “trade-off”area. Capitalist economy puts emphasis on efficiency and regardsequity as its “spillover”, that is, it holds that in the process of economic growth, equity will emerge. In discussing justice (equity)

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the main issue is the equitable distribution of income and wealth.What justice is this, as M. Friedman puts it: “That 1% of population owns 50% of everything?” And, how is it that after thepassage of two hundred years, this justice has not yet emerged? The socialist system claims to have justice as its goal, yet ithas a mistaken image of justice. In the meanwhile, the socialistposition takes efficiency as a byproduct of the issue of equity. The

socialist’s error is that they do not respect private property. Is ittrue that ownership is always obtained through theft? Proudhoninitiated sanction against private property by stating that“property is theft”. Nevertheless Proudhon not only does not denyworkers’ ownership but also considers equity important enough torightly assert that: Justice is equilibrium of opposing forces. Andthat: Justice is the supreme principle of human life.Proudhon, thus, bestows on justice a certain scientificanalytic aspect. Whileavoiding the assertion of attributing thedemise of the former Soviet Union to the supposed fall of 7philosophy of socialism, it seems necessary to bear in mind thatthe issue of equity is the issue of “rights”, and that within rights of the owner of capital (not money) to possess and enjoy the resultsgained through utilization of “his” capital.Moreover, justice is not meant to be an issue applicableonly to workers, it must encompass all members of a given society.Even when economists talk about efficiency they implicitlyconsider equity. Specifically, welfare cost of inflation, which hasoccupied a considerable volume of economic literature, is mainlytargeted toward least damage to the society. This is nothing but justice (equity).

In Islamic economics, rights of people and those of “things”have been defined prior and after the distribution of wealth. Then, justice is defined for all members of the community as anuncompromising goal. It must not be difficult to demonstrate thatthe implementation of justice as such will conduct all affairs intheir natural course. The resulting corollary is that simultaneousaccess to both stable prices and full employment (unlike capitalisteconomy) is attainable. Meanwhile, natural course of affairs whichresults from application of such a justice will create a state of equilibrium between human psychological needs and hissurrounding environment (something the capitalist economy has

been unable to attain). The second subject is that mankind has comprehended justice concept and the joy which is derived from applying justice,in some periods of human history. Then, ever since mankind8achieved this understanding of justice, using his intellect, which isintrinsically moral, he has struggled against interest (Riba). Thisstruggle goes back to hundred of years before Christ. So that:usury (Riba or interest) had been repugnant to Aristotle.Economists, later, embarked upon more detailed inquirieson interest. Proudhon is one of those who rose against interest in

such a manner that he believed: interest being abolished,exploitation through property is abolished, too. Nevertheless,serious scientific discussions on zero interest began in 1930’s.Silvio Gesell suggested “stamped money” in order to omit interest

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from economy. Maurice Allais, while publishing a book in 1947,had reached the conclusion that: the optimum real interest rate iszero.

We will suffice mentioning three other thinkers who roseagainst interest in economic literature. After Allais, anothereconomist, namely, M.Sidrauski in 1967, using a dynamic utilityfunction in which money was inserted reached the conclusion that

in order zero down welfare cost, interest rate must be equal tothat of social marginal cost. Applying it to money it amounts tozero interest. B.P.Pesek, and T.R. Sving (1967) have argued thatthe essential characteristic of money is its non-interestbearingness, and that if money were to bear interest it wouldcease to be used as money. Professor M. Friedman, too, in 1969reached the conclusion that zero nominal interest rate is thenecessary condition for optimal allocation of output factors. In1998, two economists working for the US Federal Reserve, of 9Minneapolis District, showed that for optimal allocation of outputfactors, not only is zero interest necessary condition, but it issufficient , too.

The result emerging from these studies do not strikeMuslim economists as surprises. Yet, the question remains thatunder these circumstances how banks would operate? If banks, forexample, grant interest-free loans, (considering that M.Friedmandesignates legal reserve rate banks to be 100% for purposes of economic stability), what form, then, banking will assume?Despite valuable efforts made, none of these economists has yetaddressed this vital question. We have taken up the task to dealwith this question in a book coming out soon. Having discussed

briefly the issue of zero interest in economic literature, we realizethat mankind has paid a heavy price, within prolonged years, as aresult of paying little or no attention to instructions that Islamissued. Yet, one has to admit that man has learned much throughthese processes of trail and error. What Western economists havereached on this issue is that through designating a certain goal aswelfare state, they have attained the necessary condition forrealization of justice. In short, this is nothing but zero interestrate. This is what has been carried out in Islam, which beginswith sanction against interest (Riba), and ends with the welfarestate; the one envisaged in Islam.

Then, we argue for the Islamic model of economics, whichshows the way to those who believe in the unity of Almighty God,so that they would not be misguided. We would reach the desired10destination, if the way is taken and traveled through. Thus,Islamic way is the safest and the least costly of all and it is on thisscore that all humanity, especially the capitalistic society, hasfocused attention on Islamic economics in general, and on Islamicbanking in particular.At this juncture, we would like to present a review of themain challenges and prospects that Muslim economists are facing

as listed succinctly below:Challenges:1-We must gain the courage to implement the divine rules

in the form of logical models, coherent enough to be presented to

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the world’s scientific community. We have to admit that the worldexpects us to do more. The history of serious and analyticalresearch on Islamic banking goes back at the most to fifty yearsago, while the same divine rules had existed before and have notchanged ever since. Having endured many hardships, the westernnations catered the tree of modern science. That is why we seethat the tree of science has grown to such a bulk over there, and

with the passage of every single day the bulk of scientificliterature expands even further. It can be argued that if the divinerules were available to the westerners they might have elevatedthe status of science even higher.

2-It is regrettable that only articles and seminars refer tothe benefits of Islamic banking, and that little of Islamic banking11has been practiced in few Islamic nations so that people couldenjoy its benefits.

3-The Western economists’ reaction to the theory of Islamicbanking has been somewhat deficient in character and vigor. Iattribute such a benign reaction to the existing differences of perspective and approach among Muslim economists, which ispartially normal and acceptable. Yet the remaining part of reasonfor such a reaction is due to the fact that many Muslim economistshave concealed capitalistic economics under the guise of Islamiclexicon and contracts. Interest rate, for instance, has been coveredby profit rate and it is not clear while interest has been overtlybanned in Islam, how can people discuss LM curves money marketand their derivatives? It is the same when many articles discussloan (not Qard ul-Hasan). In legal definition of loan, the obligatorypayment of surplus on the part of the borrower is interest per se,

which is Haram (banned). It is obvious that loan does not involveprofit; rather it is capital that produces the profit. Or, similarly,when discussing the opportunity cost of capital in Islamicbanking, Muslim economists imitating the Western colleagues andwithout much scientific thinking, consider a positive figure, otherthan zero, that is debatable.

4-Distinguishing money market from capital market is notan easy task, and this is exactly what professor Joan Robinson haswarned us about, so that we do not be misled. Our goal must be toconvert M-C-M relation to proper C-M-C, because it is not moneymarket which accomplishes the task of economic growth, rather it

12is capital market which must be reinforced in order to fostereconomic growth. Once J.M. Keynes showed that interest createsspeculation (a subject to which the classical economists paid noattention). It is not hard to show, on the basis of his rigorousanalysis, that speculation, too, causes interest. In other words,interest is the necessary and sufficient condition for speculation.In the meantime, there are still those who make a distinctionbetween interest and Riba, and what has been sanctioned againstin Islam is, considered by them as prohibitive, Riba. At the sametime they surprisingly enough do not consider small interest as

Haram!5-The Western monetary theorists, too, have not shown aconsiderable reaction to the above shortcoming. It seems thathaving glanced through articles on Islamic banking models,

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written by Muslim economists, the Western monetary theoristshave found those models to be very close to capitalistic banking.On this score, they are apologetically happy to have discussed amodel not different from the traditional one! That is perhaps whythe Western economists have not been cognizant of articles onIslamic banking written by Muslim economists.

6-The Westerners have declared that the science of

economics was established in 1776 by Adam Smith. Objecting tothis notion, some have considered the French as having devisedeconomics, indicating France as its homeland. Upon supposing afictitious and unfair stance to the effect of exclusion of the earlyIslamic period, we would be still faced with Ibne-Khaldoun in13more than 600 years ago who in his book, The Introduction, asacknowledged by the Westerners, is the first Muslim thinker todiscuss ways of administering a nation. Today, we find on the websites more than 4000 entries on Ibne-Khaldoun’s material.

7-The indulgence and weakness of Muslim economists(myself included) have made the Western scientists suppose thatby banning interest our position is similar to that of socialists inthat we would maintain there must be no return attached tocapital, while interest is the return attached to money, and profitis the return attached to capital. Having accepted capital marketwe admit a return to capital. Yet, rejecting money market, we arenot prepared to pay anything as return for money. Under anIslamic framework money market has no function to play, that is,it has to be obliterated. It follows that all of money marketderivatives, too, would be considered as non-Islamic. This wouldset limits to transactions in securities exchange market (limitation

would be on stocks exchange not on bonds, which would be absentbecause of interest they acquire). Securities exchange market,contrary to some misconceptions, is money market, not capitalmarket. Money market, by definition, is where loan is the centerof transaction, which is administered within a year or less. Thus,even if stocks are transacted in such a market, since the intent of the buyer and the seller is indeed to gain income, which isobtained even daily through the difference on the price of stockstransacted, then, the same M-C-M relation persists in whichstocks function as “C”. In this retained relation, the loan is14received and paid on a daily basis, while “C” functions as

collateral for the loan, and the differential rate of interest gainedthereby is the source of income thus made. Moreover, the pricingof stocks, too, in securities exchange market must conform to theIslamic rules, that is, the prerequisite conditions for realization of a proper transaction must be met. This means that the buyer isentitled to know exactly what he is buying. In current securitiesexchange markets, the buyer does not exactly know what he ownsin the community.

8-The capitalistic economy is fraught with many problems,some of which have been pointed out above. Nonetheless, we must

bear in mind that social capital is stronger in the capitalistnations as compared with developing Islamic countries, thesignificance of which should not be under-estimated in Islamiccountries. We should be able to prove that not only will these

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problems be solved in the light of Islamic banking but also newfields be opened to Muslim economists:A: One of the conditions to attain sustained growth(development) is the equitable distribution of income andwealth. It has been demonstrated (by Westerners) thatcapitalistic economy will not reach such equity.B: The capitalistic economy is faced with a conflict between

efficiency and equity. This, among others, makes one of thefallacies of capitalism. Whereas, in Islamic economics thereis no goal higher than establishing justice and fairness. Weshould be able to demonstrate that through implementation15of the Diving Rules of Islam, by which efficiency is attained,we can also reach equity. Islamic banking will accelerate thisgoal. We should also remember that Islamic community is acooperative entity in the wider sense of the word“cooperative”.C: The Western economists have recognized as genuine thefact that capitalistic economy is unable to increase aggregatedemand (AD) and aggregate supply (AS) simultaneously. That is why their monetary and fiscal policies cannot departfrom stagnation and unemployment. The cooperative Islamiceconomics, particularly where Islamic banking is concerned,is capable of such a task, and again, we should demonstratethis capability.Prospects:

1-Profit & Loss Sharing (PLS), as a principle, constitutesthe backbone of Islamic banking. The expansion of this principlethroughout a community transforms that community into a large

cooperative within which every Muslim individual would tryhis/her utmost efforts and thereby through benefiting others,he/she would gain benefit. If the interaction of individual effortswere utilized in a proper way then the community’s welfare wouldbe high enough not to let these interactions be mutually exclusive. This is also true of workers remuneration through which workerscan share the profit gained by Islamic bank’s contracts withproductive firms. In addition, the depositors will enjoy the profit16gained through banks’ participation with investors. This pointbecomes clearer if we remember that the profit rate is frequentlyhigher than that of the interest. These two factors will help the

equitable distribution of income and wealth; the necessarycondition for sustained growth. The price of manufactured goodswould fall due to two reasons. On the one hand, price decrease isdue to the omission of interest (Riba), on the other , it is a functionof decrease of wage expenditure (brought about by workersparticipation in profit). Pursuing a policy accompanied byparticipation of Islamic bank with productive firms and bydividing the proportionate profit among the depositors,simultaneous increase of AD and AS will be made possible.

2-It is interesting to notice that professor M.Weitzman,

imitating Japanese workers participation in production hasamateurishly considered it quite fit to overcome stagnation (as headmits to be inherent) in capitalistic societies. Whereasparticipation of workers is not compatible with the elementary

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principles of capitalism. Professor Weitzman, aside from mixingsubjects, has neglected the point that interest constitutes theprime fallacy of the capitalistic societies, a fallacy which will befollowed by yet more complex and larger fallacies. It is difficult toenvisage that Islamic economics, having eliminated such a fallacy,would encounter similar problems.

3-Based on existing literature, it seems that for the sake of

modeling in Islamic economics, in general, and Islamic banking, in17particular, we possess more than enough criteria and proceduresto act upon.

4-Marx once, lacking relevant expertise, omitted capital’sshare in the Industrial Revolution era and thereafter, and worriedsolely about the proletariat. Whereas Islam worries about allindividuals; workers and investors both. Could Marx have everimagined that interest would penetrate the economic life of theWestern societies that, for instance, in contemporary Germany, forevery 100 Marks spent in a family as expenditure, 1/3 goes forinterest? The elimination of interest, supposing it were inert inother areas of Muslims social life, will have the least effect of raising their purchasing power to up to 1/3.

5-Having banned interest (Riba), and having logicallyeliminated money market, speculation and all related affairs insecondary market, which involve artificial risks, Islam attempts toemancipate all men (Muslim and non-Muslim) from beingdominated by wealthy individuals who have always lived a lifeexploiting others. This emancipation comes by throughestablishment of Islamic banking. By the omission of interest fromthe whole system, money whirlpool will disappear and thus the

necessary condition for full employment (that is, the equality of saving with investment) will be created. We should not be misledby Japan’s experience. Although interest rate in Japan is nearlyzero, yet unemployment rate has been declared as 5.4%, which isexpected to reach 7% within five years. Two reasons can beoffered for not reaching full employment in Japan (despite18workers participation in profit or income gained by productivefirms). First, Japanese bank do not operate on the basis of participation, rather they lend and borrow loans, (that is, theyfunction as fund intermediary) like any other capitalist system.Second, stock exchange (of bond, stock, and commodity) is active

as ever. Speculation in these markets creates interest in terms of same goods. In other words, interest (Riba) has not beeneliminated in its wider sense in Japan. The mere existence of these interest rate create money whirlpool, which has preventedthe equality of saving and investment. In short, as an economicsystem is farther removed from capital market, getting closer tomoney market and its derivatives, the more unstable it becomes.

6-A general equilibrium model can be constructed in whichthere would be three markets of labor, capital, and of goods, onwhose coordinate diagram profit rate and national income are

made possible to be demonstrated.7-The world today has reached the point that realizes thatcapitalistic system, despite claims put forward by its earlyfounders, is not a self-regulating or self-adjusting system, and that

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capitalistic economic models must be devised based upondisequilibrium (this is being done for some time by certainWestern economists). This is the time for Muslims to be alert andvigil to use this historic opportunity for devising and presenting alogical Islamic banking system without having any reservationswhatsoever.19 8-In the final analysis, we reach the conclusion that the

research on Islamic economics, in general, and in Islamic banking, in particular, has grown within the past several years, and thatin some instances this growth has been much beyond theexpectations of researchers of the field. This growth rate is theresult of the work done by Muslim as well non-Muslim economists.We should be proud of it.

Economic problems and difficulties of many nations havebecome so complicated that capitalistic economics, as admitted byWestern economists, cannot possibly respond accordingly. TheWestern economists thought has been so contaminated byconcepts such as individualism, profit seeking , and interest (Riba), that it is hard, if not impossible, for them to imagine any otherworkable system. In order to find answers to ever growingproblems of the capitalistic world, their theorists once in a whilefind a subject here and there, and try to patch it up to or inject itinto the ailing capitalistic system.

Among these injections we can point to labor unions,syndicalism, creation of cooperatives, and The Share Economy. Ascientific approach to Islamic banking has been added in recentyears to the list just offered.

Evidently, these are not ways to completely cure the

institutionalized problems faced by capitalism. These short-termsolutions may act to pacify the wounds inflicted on the system. Todescribe a definite resolution as to the issues and a way for freeingfrom the capitalistic ailment a quote is in order: “It takes a theory20to kill a theory”. The remedy cannot be anything but that offeredby Islamic economics. Islam and its Divine Rules are not nationspecific; theycontain the message of hope for all men in allnations. It is only through Divine Rules that mankind canovercome his terrestrial problems. Men’s own solutions seem notgetting through in this complex sphere.

Mankind has paid a heavy price for neglecting the Divine

Rules, which are for his own welfare and salvation. In this setting,the modern man should prepare an alternative approach toadminister his economic affairs.

Muslim scientists should use their thinking capacity, andthe capacity of their interacting with one another, and throughavoiding mixing the content of capitalism with that of Islam, theycan present mankind an alternative route. This is not a farfetched goalbecause Muslims enjoy absolute advantage in thisarea. For this reason, we can hope to restore the glory of our pastin near future. This goal is attainable given closer, further, and

continued cooperation among scientific figures of Islamic, as wellas non-Islamic, nations.

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Islamic Banking System, Islamic Banking Concept, IslamicBanking,Afghanistan, Kandahar

Abdullah Haiwad

affiliation not provided to SSRN

October 12, 2008

Abstract:SUMMARY:The project identifies the concept of Islamic Banking, from its origin as mentioned in the Holy Qur'an andreforms being introduced to meet the requirement of today.

Section one, outlines the aims of the project. The Second section, deals with methodological issues and

attempts used to justify the choice of research variables, reasons why they were most appropriate to myproject undertaken. Section Three, of the project looks at what the Quran says about Islamic finance. Itraises the question that Islamic finance is divinely revealed and must follow the Shari'a (Islamic law), andtherefore, financial transaction can only be conducted within certain boundary. Section Four, willinvestigate the origin of Islamic banks, how it has evolved with time, and also why there is this resurgentfor this kind of financial intermediary.

Section Five, will involve a full description of the reasons for the banning of interest in Islam and itsimplication. This will directly lead to Section Six, which will look into what is Islamic bank and requirementnecessary to be classified as a bank for Muslims, and also how is the concept different from theconventional banks. This chapter will also look into the many ways thatIslamic bank provide serviceswhich is within the Shari'a.

Section Seven, will look at the practices of the Islamic banks and the permissible forms of transactions.This will lead to section eight, which will look at the problems facing Islamic banks. It will focus on aspectin terms of reforms and improvement required in order for this kind of banking system to be effective.

Finally, Section Eight concludes the project by discussing briefly the how the system is doing well andhow it still needs to improve. Furthermore I will also evaluate my methodology.

INTRODUCTION:This project will give me the opportunity to undertake a study of a particular Business and FinancialServices subject. According to Islam, God has created man virtuous and pure; He has given manintelligence and knowledge; He has surrounded him with all sorts of instruments of His grace and mercy.In return, God has asked man to act in a certain way in this world not to harm other fellow human.

This being the belief of Muslims, an attempt has been made to serve over billions of Muslims in their financial needs. Thus, my project aim is to identify the concept of Islamic Banking System. In addition, itwill look at how Islamic banking was created and why there is a need for such finance. In order to do thisI will begin by defining some of the key terms and concepts, and will provide a background and anoverview of the nature of the Islamic Bank.

http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=723038

http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=723038

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Finally, I will investigate the current situation and necessary reforms and improvement required for thiskind of system to become successful in meeting the needs of the Muslim people.

RESEARCH METHODS:The research methods used to gain the best possible knowledge and informationabout Islamic Banking System was to conduct a literature research. Initially I had anticipated using twotypes of methods to do my project, in addition to research into secondary materials, I had also intendedto undertake Unstructured Interviews - to enable me to gain an insight into the Islamicbanking system.Clearly there are many advantages attached to this type of research method. Firstly it would haveenabled me to understand and find out my respondents personal views and concerns more effectively, byprobing deeper into the question and answers. This is because they would be able to talk freely, andeager to speak out about their experiences of Islamicbanking systems. This in return would have beenvery informative and useful for me as the researcher. However, I did get the opportunity to visit mosquesand borrow literature, and ask the Imam for explanations on issues concerning Islamic banking,particularly issues to do with interests and the Islamic rules and regulations.

As with all methods, disadvantages in constructing 'unstructured interviews', could have posed for me thefollowing problems. To begin with, I would have probably gained opinionated response, as the interviewis very open and doesn't necessarily mean answers will be objective. Also added to the issue of beingopen and broad, respondents would talk about irrelevant issues. Thus, this can become very time-consuming, as one has to patiently listen, until respondents give you something relevant, in betweenissues that are unrelated to researcher's area of interest.

Moreover, it is also difficult and time consuming, when it comes to actually gaining access to theperson(s) you want to interview, as well as difficulties faced when analyzing results forming quickconclusions or even summary. (Floyd& Fowler, 1984).

SECONDARY MATERIALS:The main method used to gather information and accounts for the project were throughmeans of secondary research, which can also be referred to as indirect method of data collection. Here Iconsulted academic books and journals from the university and public libraries, these included literaturesuch as: Encyclopaedia of Islamic Banking & Insurance, Islamic Economics, & the information on theFinancial Times etc. Furthermore, I also gathered information through searching the Internet into relevant

websites.

Interviewing and the use of questionnaires are two methods of data collection that rely very much on theinvolvement, participation and contribution of the respondents. These methods act directly on therespondents, who in turn provide information about themselves or other people. There are methods,however, that does not rely on the direct participation ofrespondents. In these methods data are obtainedwithout the knowledge of the subjects, in an indirect and non-disruptive way - these methods are called'indirect' or 'unobtrusive methods'. (Sarantakos), 1998).

Documents have always been used as a source of information in all kinds of research, either as the onlymethod or in conjunction with other methods. They are employed in the context of many diverse studies,such as quantitative studies, qualitative methods and case study research. It is most unusual that anyresearch study is carried out without employing some form of documentary method (e.g. a library

search). (May 1997).

Documents are usually referred to as 'secondary materials'. Thus their analysis is therefore calledsecondary analysis. They are called secondary because they are not primarily developed for the study inwhich they are used. Documentary research can take many forms, of which the following seem to bevery popular: Qualitative research, Quantitative research, Descriptive-comparative research, Contentanalysis. (Sarantakos, 1998).

Secondary Literature research (documentary methods); demonstrate a number of strength andweaknesses. They are therefore used only if and when the strengths outweigh the weaknesses. Theadvantages most commonly mentioned, include: gaining quick and easy accessibility to information - withavailability of the Internet, electronic media and spread of personal computers. Also theavailability of data banks and sophisticated computer programs. Retrospectively- documentary methods

enable researchers to study past events and issues. Furthermore, in most cases, writers producedocuments without being requested to do so by researchers. This reduces researcher bias significantlyand it can be highly objective. This also gives relevant academic arguments and provideswork of academic scholars, and also gives current debates. Literature research is also low cost, andmore economical than most other types of research. Often they are the sole source of information (e.g.

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when studying past events). And the quality of information obtained is of high quality and it is possible for it to be retested. In this way the methods itself and the act of measurement do not affect the results.

A literature research can be undertaken, quite easily as books and other literature can be obtained atones own time and convenience, rather than having to rely on a respondent i.e. in the case of interviews.It saves a great deal of time, and at the same time gain access to information that might otherwise beimpossible i.e. through participant observation.

However, secondary research methods also demonstrate some limitations, of which the researcher asmyself was aware. Firstof all it can be time consuming and difficult to analyze the results. Therefore timeconstraints make it difficult to look at all relevant literature. Another drawback to secondary data is that itdoes not provide detailed accounts. Furthermore, problems ofreliability and validity as with all literature,is geared to a specific group therefore are one sided and perhaps biased. Some materials are notcomplete, up to date or may be difficult to get access to. (Sarantokas, 1998).

Despite these limitations, literature research is a very useful tool for researchers and an indispensableone, particularly when the research is focused on events of the past. In such cases this method is theonly way of collecting data on this issue.

WHAT COULD HAVE BEEN DONE:I could have attempted to make the project more interesting, by using other methodologies whilstundertaking my research. However, what is important to remember is that - it is not so important thenumber of research methods used, but which is the best and appropriate and reliable for the particular project interest.

Thus, participant observation, quantitative interviews and questionnaires, and ethnographic interviews onthe Islamic bankingsystem, would have all been either inappropriate or not suitable due to time andresource constraints. Participant observation is a qualitative method, which is a useful method to gain aninsight into an organization such as banks - as William Whyte (1996) suggests: participant observationcan obtain a deeper level of knowledge and more insight. The way of understanding a context is throughinteractions and meaning, understand it from your own point of view the meanings of setting, culture,values and norms. Nevertheless, the problem with this method is that from the observers point of view, itis one sided, thus could be biased as one is participating for a short time, generalization cannot be made.

WHAT THE HOLY QURAN SAYS ABOUT ISLAMIC FINANCE:The Qur'an and Sunnah have both placed tremendous stress on justice, making it one of the centralobjectives of the Shari'a. It is important that the term Shari'a, which will appear many times in the project,is understood. Shari'a literally means a straight path. In Islamic terminology, Shari'a means the way of lifeprescribed by God through Prophet Muhammed. The Qur'an teachings and the practices of the Prophet,called the Sunnah, make up the Shari'a. (Chapra, 2000).

One section of the Shari'a is related to beliefs, while the other is related to individual and collective life.Fiqh (Islamic Law) is the part of the Shari'a, which deals with the latter. It specifies the Do's and Don'ts,the Permissible (Halal) and the Forbidden (Haram). (Chapra, 2000).

Since Shari'a is a comprehensive term in Islam and covers all aspects of human interaction,irrespective of whether it relates to the family, the society, politics or economics. Also

irrespective of whether the object is a human being, animal or the environment. This has wideimplications, the most important of these is that resources provided by God to mankind are trust andtherefore must be utilized in a manner that the well-being of all is ensured, irrespective of whether theyare rich or poor, male or female, and Muslim or non-Muslim. (Chapra, 2000).

In the field of economics, Islam demands the use of resources in an equitable manner that thehumanitarian goals of general need-fulfillment, optimum growth, full employment, equitabledistribution of income and wealth and also economic stability are realized. Therefore Islamic Banks haveunique characteristics because of their specific nature and setting their principles and rulesfrom Islamic Law (Shari'a). In Islam everything is owned only by Allah and man has been permitted touse this, only according to the Shari'a. (Chapra, 2000).

The main regulation governing utilization of funds in the Islamic context:

1) Prohibition of transactions on a 'Riba' (interest) basis. Shari'a prohibited usury absolutely,regardless of its percentage, whether it was high or low. The usury gain is forbidden. (Interest will belooked upon in more details in later chapter).

Those who devour (take) interest (riba) cannot stand as the one whom the Satan, by (his touch, drives

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him to madness. That is because they say: Trade is just like riba, whereas Allah permitted trade andforbade riba. The one to whom an admonition from his Lord comes and he refrains (in obediencethereto), he shall keep (the profits of) that which is past, and his affair (henceforth) is with Allah. As for him who returns (to usury), such are rightful owners of the fire. They will abide therein eternally. (Al-Baquarah: 275 - Cited in Nabhani, 2000, P: 26).

2) Trusteeship: The idea of trusteeship has been central to all religious views of the economy; Islamreinforced the view that man's ownership of resources is held as a trust, the real owner being God, towhom the trustee is accountable. Men are only acting as trustee and therefore they should try with all hiscapabilities to invest funds and develop the national resources in such a way that the outcome isorientated to serve the community. Basically material pursuits should go with moral pursuits.

Hallowed be He in whose hand all dominion rests, since He has the power to will anything: He hascreated death as well as life, so that He might put you to a test (and thus show that) He alone is Almighty,Truly Forgiving.

Believe in God and His Apostle and spend on others out of that which He has made you trustee: for,those of you who have attained to faith and who spend freely (in God's cause) shall have a great reward.(Nabhani, 2000, P: 28).

3) Making money out of money is contrary to Islamic law. Wealth should be achieved through legitimatetrade and the creationof real assets. Islam looks at economic well being as a means to peace, freedomfrom hunger and freedom from fear of, or domination by, any other than Allah. Beyond thesatisfaction of basic needs, the ultimate objectives of earning and spending money are moral andspiritual. This rules out the seeking of economic gains at the expense of moral and spiritual values. It isagainst Islamic value to hoard money.

Oh you who have attained to faith! Behold many of the rabbis and monks do indeed wrongfully devour men's possessions and turn (others) away from the path of God. But as for all who lay uptreasures of gold and silver and do not spend them for the sake of Allah- give them tidings of grievoussuffering (in the life to come). On the day when that (hoarded wealth) shall be heated in the fire of helland their foreheads and their sides and their backs branded therewith, (those sinners shall be told:)'These are the treasures which you have laid up for yourselves! Taste, then, (the evil of) your hoardedtreasures'. (Siddiqui, 1995, P: 08).

4) Moderation: Consumption should be rationalized and expenditure should be conducted with thrift,avoiding extravagance. Islam discourages 'show-off' living and involving too much in luxuries. Muslimsshould take into consideration what is available to his fellow human beings before enjoying.

Oh Children of Adam! Beautify yourselves for every act of worship, and eat and drink (freely) but do notwaste. Verily, He does not love the wasteful. (Siddiqui, 1995, P: 08).

5) Wealth should directed in the 'Halal' (religiously acceptable) way, which will benefit all individuals. Itmust not be spent with a motive of exploitation or in 'Haram' (religiously forbidden) way, or harming thesociety or individuals. Funds are not to be employed to monopolize the resources, utilities or necessities of the society. Islam opposes monopolies and cartels.

Oh you who believe! Verily khamr (alcohol/intoxicants) and gambling and idols and diving arrows are onlyan infamy of Satan's handiwork. Leave them aside in order that you may succeed. Satan seeks only tocast among you enmity and hatred by meansof alcohol and games of chance, and to turn you away fromremembrance of Allah and from the prayer. Will you then stop (doing that)? ( Nabhani, 2000, P: 28).

6) Care for others or helping behavior is a fundamental aspect of Islamic economic behavior. In Islamhelping behavior is required because human beings are social creatures and therefore being selfish insocial relation is counter productive. Men serve their interests best when each individual cares for thewelfare of others while striving to protect and promote his own interest.

Thus, when they are told, 'spend on others out of what God has provided for you as sustenance', thosewho are bent on denying the Truth say unto those who believe, 'shall we feed anyone whom, if (your)God had so will, He could have fed (Himself)? Clearly, you are but lost in effort. (Manzoor, 1999, P: 33).

7) Zakat (charity), one of the five pillars of Islam must be deducted from wealth and given to the poor andthe needy and distributed according to the Shari'a. In Islam, social wealth increases when the rich givepart of their wealth to the needy. Maximization of private wealth as the main reason therefore meanspeople are only seen as a profit. Islam states that in society, which has such people, the weak are

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vulnerable against the strong.

That which you give in usury in order that it may increase on (other) people's property has no increasewith Allah; but that which you give in charity, seeking Allah's countenance, has increase manifold. Goddeprives usurious gain of all blessings, whereas He blesses charitable deeds with manifold increase. AndGod does not love anyone who is stubbornly ingrate and persists in sinful ways. (Khan, 2000, P: 44).

8) Wealth should be acquired through legitimate trade and the creation of real assets. A fixed charge oncapital is unjust, since the results of productive enterprise in which borrowed capital is invested are notcertain. Risk and reward go together. Therefore 'no risk no return'. The Prophet said. Islam has a positiveattitude towards wealth. The Prophet is reported to have said that if wealth is properly acquired then it isa good thing for all mankind. He also said that a productive enterprise is looked upon as ameans of serving the cause of Allah.

And spend (freely) in god's cause, and let not your own hands throw you into destruction; and perseverein doing good; behold, God loves the doers of good. (Nabhani, 2000, P: 27).

HISTORY OF ISLAMIC BANKS:It is well known that Islam strictly prohibits interest both the giving and charging of interest. In theearly history of Islam, the prohibition against interest was strictly observed, but with the decline of values,financial practices based on interest began to influence Muslim society. The period of colonial rule, theinterest system became established as the norm in Muslim countries. After freedom from colonizationand the resurgence of Islam, the demand in Muslim countries to follow their economic system based anIslam increased. One of the significant developments in the Muslim world during the last two-decade isthe emergence of Islamic banking. Even though attempts have been made to organize normal bankingactivities in more Islamiccontext during the sixties, the concept of Islamic banking is even older. Thestrong disapproval of interest in Islam led many Muslim thinkers to find ways that banking activities canbe done without interest. (Manzoor, 1999).

The practice of Islamic banking did not start at the national level; instead individual Islamic banks wereestablished in many countries during the seventies. These Islamic banks had to operate with theeconomic and legal constraints of the country. They also had to face competition from interest-basedbanks, which were already established in the system. This environment gave little protectionto Islamic banks, which are based on sharing (or partnership). Therefore the low levels of honesty and

trustworthiness in the market, the poor system of audits and accounts, lack of means for monitoring abusiness and the failureof legal system to help the finance providers in case of default by the fund-users,were some of the reasons preventing Islamicbanks from applying the practice of profit-sharing. Insteadthey turned to trade and industry as partners, sometimes even as sole proprietors, so that they couldhave full control over the use of funds. (Khan, 2000).

Although Islamic banks are seen as another latest innovation in the financial world, In fact it has a verylong history; the origins can be traced back to the very beginning of Islam. The 'Mudaraba' (will be lookedin more depth later) is an ancient financial instrument, which was used by the Prophet himself; who actedas an agent for his wife. Such partnership performed important economic function; they combined thethree most essential factors of production, namely: capital, labour and entrepreneurship. The latter twofactors usually can be combined into one. The basic structure of the current Islamic bank is based onthis. (Usmani, 2002).

A special mention must be given to Tabung Haji in Malaysia, a financial institution, which played animperative role in the evolution of Islamic banks. The reason for the creation of this institution was due tothe demand that money for pilgrimage (Hajj) to Mecca (one of the pillars of Islam) should beclean of interest, which wasn't possible with conventional bank. The objective of Tabung Haji was firstly,to enable Muslims to save in order to provide their expenses for performing the pilgrimage. Secondly, toenable Muslims, through their savings, to participate in investment according to the Sharia. Thirdly, toprovide for the welfare of Muslims on pilgrimage. (Ahmed, 1995).

In 1963, Tabung Haji started with 1281 depositors and a total of 46,600 Malaysian dollars as deposits. By1985, this had increased to 867,220 depositors with total deposits over one billion Malaysian dollars, andhad 65 branches. Although strictly speaking, Tabung Haji is not a bank but it operates similarly. Itperforms two important banking functions, accepting deposits and making investment. However, due to

its success it gave courage and confidence to Muslim thinkers that Islamic banking can work. (Ahmed,1995).

Some pioneering Islamic banks on a very modest scale were established in Egypt in the 1960s andoperated as rural social banks along the river Nile, where banking didn't exist at the time. The

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idea of Interest-free banking in these rural areas proved successful and therefore gave the boost topromote a more substantial movement towards a new Islamic economic and financial system. The veryfirst Islamic bank to be developed as a result was the Nasser Social Bank, which begun operating inCairo, Egypt, in 1972. Then in 1975 Dubai Islamic Bank was established. (Ahmed, 1995).

The late King Faisal of Saudi Arabia played an integral part towards thedevelopment of current Islamic Banking System. It was his belief that that since the Qur'an prohibitedinterest and laid down specific rules and regulations on how Islamic economic should be conducted. Hefelt that Islamic nations must create a structure, which would comply with Islamic Law and also modernfinancial techniques in order to produce a viable financial system, free of what is prohibited in Islam.(Khan, 2000).

In 1970, during the second Islamic conference of Foreign Ministers, it was proposed thatways of establishing an internationalIslamic Bank for Trade and Development, together with aFederation of Islamic Banks should be studied and examined. Experts from eighteen Muslim countriesexamined the proposal and recommended that interest-based financial system should be replaced by asystem of participation schemes linked with profit and loss sharing. Also it was decided that a FederationofIslamic banks together with an International Islamic bank should be established. (Ahmed, 1995).

In 1975, the Islamic conference of Finance Ministers in, Saudi Arabia approved theestablishment of the Islamic Development Bank (IDB) with capital of two billion Islamic Dinars. Themember states of the Organization of Islamic Conference became members of the bank. Thecreation of the Islamic Development Bank (IDB), gave push to the Islamic banking movement. The IDBwas established as an international financial institution according to the declaration made in the 1973Conference ofFinance Ministers. The purpose of the IDB is to promote the economic development andsocial progress of the Muslim community, individually and jointly, in accordance with the principles of theShari'a.

It was the first time an international financial institution was allowed to conform to the Shari'a. The officialpublications of theIslamic Development Bank declares that it is clearly and unequivocally committed tothe principles of the Shari'a in its conduct of all its financing operations and the performance of itsactivities, and it tries constantly to identify the modes of financing that conform to the Shari'a. With thedevelopment of the IDB, a number of Islamic banking institutions have been established around theworld. Currently as many as 53 countries have Islamic banking institutions and Iran, Pakistan and Sudan

have reorganized their entire banking system along the Islamic lines.

When the concept of Islamic banking with its ethical values was propagated, financial world were veryskeptical and treated the idea as a Utopian dream. However, Islamic banking is no more just a wishfulthinking. Today, Islamic banking is estimated to be managing funds of around $200billion. Its clienteleare not just confined to Muslim countries but spread over Europe, United States and the Far East.(Mirakhor, 1995).

THE CONCEPT INTEREST IN ISLAM:One may wonder why interest is getting a special mention. The reason is that interest is very importantwhen dealing withIslamic banking and therefore will need to be explained from an Islamic point of view. Itmust be understood that interest freebanking alone cannot be termed Islamic, there are other conditionswhich must be met before it can be fully classified as anIslamic bank.

Interest may be defined as "the payment made by borrower to lender for the money borrowed and isnormally expressed as the rate percent per year". (Rickett, 1999).

From an Islamic point of view, interest is defined as "a prefixed rate for use or borrowing of money". It isthis 'prefixed rate', which is known as 'riba' in Islamic economics, which has been termed as 'somethingundesirable'. (Usmani, 2000).

There are two types of interest which exist:Riba An Nasiyah; this is defined as excess, which results from predetermined interest which a lender receives over and above the principle the premium which is paid to the lender in return for his waiting asa condition for the loan and is technically the same as interest. This is the main type of interest as it isdirectly mentioned in the Qur'an.

Riba Al Fadl; this is defined as excess compensation without any consideration resulting fromsale of goods. (Usmani, 2000).

Interest in the Qur'an (Refer to Appendix 1).

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1.First revelation (surah al-Rum, verse 39)."That which you give as interest to increase the peoples wealth increases not with God; but that whichyou give in charity, seeking the goodwill of God, multiplies manifold." (30:39).

2.Second revelation (surah al-Nisa, verse 161)."And for their taking interest even though it was forbidden for them, and their wrongfulappropriation of other peoples property. We have prepared for those among them who reject faith agrievous punishment." (4:161).

The Reason behind the Prohibition of Interest:The Islamic law of prohibition of interest is not based on economic theory but on Divine Authority, whichconsidered the charging of interest as an act of injustice. Islam recognizes that everything in the worldhas some usefulness, goodness or utility in them. However, in Islam just like any other way of livingrecognises that some things have more benefits and less harms and therefore are called beneficial.However, there are also things that have more harm and less benefit, therefore considered harmful anduseless. Even in the Qur'an, while declaring liquor and gambling to be prohibited, proclaimed that theyhave some benefits but the harm they do is far greater than the benefits they provide. Therefore, thesecannot be called good or useful. (Khan, 2000).

In the case of interest in Islam it is not seen as any different. Interest does have some benefits however the harm it does in this world and the hereafter is too severe compared to the benefits from a Muslimperspective. It is said that even if borrower faces a loss, he still has to pay an excess amount over theamount borrowed, which is seen as exploitation, whereas the lender on the other hand gets an increasewithout any effort.

When Muslim countries were colonized and followed the west in their economic field, some westernizedMuslims in the 19th century, saw the increasing progress of the west in trade and industry and theshattering economic condition of Muslims states and became aware of the fact that banking is inevitablein the field of trade and industry not only on national level but also internationally. This prompted them tosay that commercial interest was not interest because without it there would be problems interms of industrialization and economic progress. Only interest prohibited in the Qur'an and Sunnah isforbidden in Islam. (Khan, 2000).

However, Muslim scholars explain that modern theories of interest only attempts to justify theexistence of institution (i.e. Banks), which has become deeply established in modern economies. Their argument against some of the general reasons given for the existence of interest:

1) "Interest practiced during the days of the Prophet was only Usury"The argument against this is that in Islam when prohibiting something it doesn't only prohibit one form butall forms that might erupt in future. The change doesn't change the ruling, for example Qur'an hasprohibited the following:

Liquor: During the time of the Prophet its form and the way of production was totally different fromthat of the present day but the ruling remains unchanged even though the form has changed drastically.

Pork: Irrespective of how clean the present day breeding of pigs may be, pork will stay prohibited.

Corruption/Immorality: Although a lot of sophisticated ways have been developed from the time of Qur'anrevelations banning it, the ruling stands forever.

Therefore the same applies to interest. By claiming that it was in a different during the Prophet's timedoes not change the ruling. In Islam time is irrelevant and therefore if something is forbidden then itremains forever. (Mirakhor, 1995).

2) "Interest is a reward for savings"Muslim scholar responds that such payment could only be explained, from an economic position, if savings were used for investment to create additional capital and wealth. They argue that the answer tothe question of whether there is an increaseof wealth due to the savings depends on what he does withthe money he saves. He may hoard it or use it to buy a bond without they're being an increase of capitalwealth created as a result of his savings. When an individual saves, his savings gives rise to

creation of an asset or a debt, however, as a rule, he has no say to decide which it will be. According tothe scholars, in the absence of parallel increase of new investment either a debt is created or an assetwill change hands but there will be no rise to wealth. Therefore, the act of abstaining from consumptionshould not entitle anyone to a reward. (Mirakhor, 1995).

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3) "Commercial interest did not exist in the days of Prophet"They respond by glancing through the Islamic and pre-Islamic history of Arabia, it will show that thistype of interest did exist at the time. They provide the following example to argue their case. History of the city of Makkah and Ta'if shows that they acted like clearing houses. They advancedcash for commercial purposes and charged interest in case of default by traders, and thisearning of interest was their trade. The tribe of 'Saqeef' advanced cash on interest, which was not onlyrestricted to cash but also to commodities between wealthy tribes (who were usually traders andbusinessmen) for commercial purposes and not for consumption and personal needs. One of theways of receiving interest was to double the principle amount plus interest in caseof non-payment of loanand this practice was applied to both cash as well as commodities. They argued when the Qur'anprohibited interest that interest based loans is a type of trade just like rent received from assets. At thetime of signing the peace treaty with the people of Ta'if, the Prophet imposed two conditions; first thatthey give up of interest owed to and from them; secondly total elimination of interest-based transaction.(Mirakhor, 1995).

4) "Interest is justified as productivity of capital"Scholars respond that although the marginal productivity of capital may enter as one factor into thedetermination of interest rate, interest per se, has no relation with capital productivity. Interest they argue,is paid money, not on capital, and has to be paid irrespective of productivity. In distinguishing betweeninterest as a charge for the use of money and a yield from the investment of capital. The scholars arguethat it is an error of modern theory to treat interest as the price of return for capital. They say money isnot capital; it is only potential capital, which first needs to be transformed into productivity, for example,by entrepreneurship. The lender has nothing to do with the conversion of money into capital and using itproductively. (Khan, 1999).

5) "Interest arises as an inevitable consequence of the difference between the value of capital goodstoday and their value tomorrow"While Muslim scholar don't deny the difference of value between present and future goods. They say thisonly explains its inevitability and not its rightness. It explains why borrowers are willing to pay interest andwhy lenders are able to get this. They argue that interest based on this aspect is only theoretical rather than a reality and that the so-called 'pure rate ofinterest', resulting from the time factor in valuation maynever enter into the calculation of suppliers of funds and interest is never paid for that reason. Even if the

basis for time preference is the difference between the value of commodities this year and the next,Muslim scholars argue, it seems more reasonable to allow next year's economic conditions to determinethe extent of the reward. (Nabhani, 2000).

6) "Reward for lending money"Muslim scholars maintain, when a person loans money, the funds are used to create either a debt or anasset (i.e., by investment). In the first case, there is no justifiable reason why the provider of fund shouldreceive a return. Nor is there a justification from the point of view of the economy, nor from thepoint of view of social justice, for the State to force an unconditional promise of interest paymentregardless of the use made of the borrowed money. However if the money was used to create additionalcapital wealth, then they argue why should the lender be entitled to only a small fraction (represented byinterest rate) of the wealth created by his loan. Therefore in Islam the lender should be rewarded for theextent of the involvement of his financial capital in creating the wealth.

The scholars argue in Islam there is no objection to profit as a return on entrepreneurial effort and onfinancial capital; in fact, they say it is encouraged. Only the concept of interest as reward for the mere actof refraining from consumption is against the law of Islam. (Siddique, 1995).

THREE TYPES OF ISLAMIC BANKING SYSTEMS:Islamic banking system can be grouped into three categories, each representing a distinct model.Firstly, in the private sector, there are banks, financial institutions, investment companies, leasingcompanies and mutual funds trying to operate without interest. They are mostly owned by entrepreneursand private investors, however some governments and international financial institutions provide somefinancial support. In some countries, special laws have been introduced to help interest-free banks tofunction effectively. The two major financial groups are Dar al-Mal al-Islami and al-Barakah Dallah belongto this category.

The Dar al-Mal al-Islami Group consists of 21 operating subsidiaries, including 3 Investment banks, 4Investment companies, 4 Takafol/Retakafol companies (Islamic alternative to insurance/reinsurance) and4 business companies. And are based in the Arabian Peninsula, Bahrain, Malaysia, Indonesia,Bangladesh, Egypt, Pakistan, Sudan, Senegal, Niger, Guinea, West-Africa and Luxembourg. (Rahman,

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1996).

The Dallah Al-Baraka Group of Islamic financial institutions consists of several Islamic commercial andinvestment banks and associated companies located in the UAE, Tunisia, Turkey, Bahrain, Pakistan,India, Jordan, Bangladesh, Yemen, Sudan, Mauritania, Algeria, Thailand, South-Africa, Luxembourg, andseveral other countries. (Rahman, 1996).

Secondly, at least three countries have tried to develop a state sponsored process for theremoval of interest from the entirebanking system. Pakistan, Sudan and Iran have converted their financial systems according to the Shari'a. All the financial institutions in these countries are conductingtheir transactions on an interest-free basis. Instead of establishing interest free banks in the privatesector, the idea was to first establish 'interest-free counters' within the system. Then extend the interest-free system to the whole banking sector, so as to operate on new principles under the protection of statepolicy and central bank guidelines. The aim is not just one or two Islamic banks but to change the entirefinancial and banking system and eventually the whole economy so as to conform to Islamic way.(Manzoor, 1999).

The third kind is the mixture of the two, for example Malaysia. They have established under the country'slaw a totally interest-free Islamic bank with a distinct law and identity. They also have conventionalbanks, which can have interest-free system within them. So far 52 conventional banks have opened suchsystem.

WHAT IS ISLAMIC BANKING?Modern commercial banking activity is based creditor-debtor relationship between the depositors and thebank on the one hand, and between the borrower and the bank on the other hand. Interest is viewed asthe price of credit. The Islamic view about loan is that they should be provided free of charge and that thecreditor should not take any advantage of the borrower. Therefore commercial banking inan Islamic framework is not based on the creditor-debtor relationship. To understand whatconstitutes Islamic banking, the crucial point is that whether it is a direct investment or financialintermediation, there cannot be a fixed predetermined return on capital, loans or credits. (Usmani, 2002).

This doesn't mean that Islam stands for zero rate of interest, which causes a lot of confusion. Islamdoesn't prohibit return on capital because there has to be a reward for it; however capital is consideredas being productive and therefore is entitled to a share from what is being produced, in which capital

plays a major part. Expecting a reward from capital is seen as just and reasonable. However what Islamchallenges is the right of money or loans to a predetermined fixed and assured reward without taking ashare in the risks or a stake in the project. Therefore in Islam it is ok to provide a loan to someone aslong as the return is stated before hand but there can be no increase on the loan. However if return isexpected then risk sharing must involve, in Shari'a reward and risk go together. As all forms of interest isprohibited, whether it is simple or compound, low or high rate, personal or institutional, private or public;therefore whatever the category any predetermined fixed increase without sharing the risks of the projectis classified as interest which is prohibited in Islam. In Islam if you want to share the fruits then you haveto be willing to share the risks, otherwise it is seen as exploitation of one person, i.e. the lender or thecreditor. (Rahman, 1996).

CHARACTERISTIC OF ISLAMIC BANKING:

The major characteristic of the Islamic system of banking involves five major elements.

Firstly, Islamic finance involves a system of equity sharing and stake-taking. It works by the principle of avariable return depending on the actual productivity and how well the project performs. The project canbe in different forms such as specific or general, individual or institutional, private or public. However the Islamic principle remains of equity and reward sharing unlike the western concept of loan-interestrelationship.

Secondly, a very crucial point relates to the whole vision of an Islamic economy. Islamic banking plays amajor part in that vision, which is to an extent a revolutionary change as it calls for new approach to theeconomy. Islam wants the economy, its major monetary and business dealings, to move away from debt-based partnership to an equity based and stake taking relationship. While their will still exist some debt-based transactions in the Islamic system but it will be based on the principle of'Quard Hasana' (where the

principle amount is assured, but no increase on that). The overall purpose of the economy will bearranged towards equity based and risk sharing. (Chapra, 2000).

Thirdly, in the Islamic way ethics will play a key role. The ethical and social dimensions will be crucial toall economic activities, there will exist framework of 'Halal' (permissible) and 'Haram' (prohibited) within

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which all economic activity, private and public, has to take place. The ethical issue will operate atdifferent levels and therefore morals will play effect the conscience of the entrepreneur and the firm, thesociety, the legal framework and the supervisory of the state. This means activities which would betreated in the capitalist system as productive because it has some demand (e.g. pornography, gambling,prostitution, the promotion of alcohol, etc), however in the Islamic system will be prohibited. (Chapra,2000).

Social and ethical will be part of the Islamic economic system. It will ask question such as: what are theobjective for which money is being acquired? Will it benefit individuals, society and humanity? Will it leadto the establishment of a just, honorable, sustainable society; or will it result in exploitation, moraldegeneration, social tensions and inequalities? These questions will be as relevant as the profitabilityand economic viability of the project in the Islamic system. (Khan, 1999).

Fourthly, Islamic Banking is entrepreneurial driven. It is directed not just towards financial expansion butalso towards physical expansion of economic production and services. In the Islamic economy moneywill not produce money; it is expected to finance talent, innovation and new ideas, skills andopportunities. Whereas, conventional banking operates predominantly on the basis of financial collateral,therefore the more money you have, the more you can get. This means that the viability of a projectmainly depends on the financial worth of the borrower; meaning that low collateral can reduce thechance of getting a loan, even if the project is viable and the person has impeccable character. Whereas,in the Islamic system collateral is not ignored but it is reduced, through the trustworthiness of the person,the viability and usefulness of the project; which is more important then the financial worth of theborrower. This means in the Islamic system greater emphasise is placed on human needs such as fair distribution, equity, community and individual development. The result being small savers, investors,trader and producer becoming more important. Islamic banking is more oriented towards the community,talent and entrepreneurship. (Usmani, 2002).

Finally, the Islamic system is non-inflationary; this is a very important and fundamentalaspect of Islamic banking. The linkage between financial expansion, money supply and the physicalexpansion of the economy is a result of the financial and bankingdynamics of the current time, whereasthe Islamic banking and finance restores the balance between these three variables. Stability in thevalue of money is a primary goal of an Islamic economy.

ISLAMIC BANKING BUSINESS PRACTICES:

Like conventional banks Islamic banks attract financial resources from individual and institutions, anddirect them to people who requires them. Even though Islamic banks act like financial intermediary asnormal banks, however the big difference lies on how those functions are conducted. It is well known thatinterest-taking banks has deposits of different maturities, paying different rates of interest onthem. Islamic bank would operate the following ways on deposits:

1) Current AccountAll Islamic banks has current account. They are very similar to the one's available in conventional banks,i.e. the deposit is to be returned on demand. The bank may use the funds for other things at its own risk.No profit is paid to the depositor but they enjoy facilities such as cheque, money transfer, etc.

2) Savings AccountThe procedures and formalities is identical to the conventional system. However, in Islamic saving

account, the depositor may allow the bank to invest the money deposited in which case it becomes aprofit-and-loss sharing account. As interest is forbidden, profits will depend the investment of thoseaccounts.

3) Investment AccountThese accounts may be opened either by individuals or companies for any specified period. Thedepositors do not receive any interest; instead they are entitled to a share in the profit. The profits areshared by the depositors in an agreed proportion according to the amounts of their deposits and theperiod they are held by the bank. Usually withdrawals are not allowed from these investment accountsexcept under special circumstances, for which some notice is required. Therefore the depositor loosesout on the profit on the amount withdrawn.

4) Limited Period Investment Deposits

Some Islamic banks also accept investment deposits for a specified period, which is determined by thedepositor and the bank. The contract can be terminated at end of the period, but the profits aredistributed and accounted at the end of the financial year.

5) Joint/General Investment Accounts

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Islamic banks establish an investment pool. The investment pool takes the form of a general investmentaccount in which investment deposits of different maturities are pooled together. They are not tied to anyspecific investment project but are utilized in the different financing operations of the bank.

6) Unlimited Period Investment DepositsThese investment deposits are automatically renewable without specifying the period. Giving a specificperiod of notice to the bank, usually three months, can terminate them. No withdrawals or increases inthe amount of the deposit are permitted during this period. (Usmani, 2002, P: 105 - 110).

PERMISSIBLE FORMS OF TRANSACTIONS:Islamic financing technique is significantly different from traditional banks. Conventional banks acceptdeposits and lend them to the borrowers. The bank's profit is the difference between interest paid todepositors, and interest earned from borrowers. Interest is always predetermined, and if delay occurs inrepayment, penalty interest is usually charged, which is higher than the original rate of interest. Inthe Islamic financial system money does not earn money without collaboration between capital and effort.Return for the investor (who provides the capital) and the bank (which makes the effort) depends uponthe actual profit made on the transaction. In disallowing interest but permitting profits, the Shari'a hasdeveloped six specific forms of financial transaction as means of earning profits without resorting tocharging interest. (Usmani, 2002).

1) MUDARABAHMudaraba is a contract in profit sharing, with one party providing funds and the other providing expertise.The funds are used for Islamically permitted activities and their use is subject to scrutiny by the fundprovider. Therefore mudaraba is a contract between the fund provider (Rab al-Maal) and themanagement agent (Mudarib). The agent is provided with financial resources to run a particular project.The profit is shared between the fund provider and the agent in an agreed amount. Loss that may occur is the liability of the fund provider and the agent loses his share of the profit. However, if it is found thatthe agent was breach of his contract, frauds or there was deliberate negligence, then the agent isresponsible for the losses. Also the agent is not allowed to buy or sell Mudaraba assets against/for hisown possessions.There are two types of Mudarah that exist:

Al Mudaraba Al Muqayyadah (Restricted Mudaraba): The fund provider may specify a particular business

or a particular place for the agent; therefore the agent will invest the money in that specific project.

Al Mudaraba Al Mutlaqah (Unrestricted Mudaraba): In this instance the fund provider gives full freedom tothe agent to undertake whatever project he feels is most suitable. However the agent cannot lend moneywithout the consent of the fund provider. (Manzoor, 1999, P: 49).

Mudaraba is best suited for project and trade financing. For this kind of financing, an Islamic bank mayuse its own funds or its client funds but not together as it will become another form of financing(Musharaka). If the bank uses the client's funds without using any of its own then the bank acts as anagent for the fund provider. After the conclusion of the project the bank gets an agreed share of the profitfor acting as the agent. In the case of the bank being the fund provider (acting as Rab al-Maal), beforeproviding finance the bank has to check the project's feasibility, as the agent cannot be responsible for genuine business loss. Also the bank should monitor the project after the funds have been given.

(Hasanuzzaman, 1995).

Mudaraba is usually only for certain period. It is necessary for the validity of Mudarabah that both partiesagree the proportionof the profit that each is entitled right at the beginning. The lender or the agentcannot allocate a lump sum amount of profit for any party nor can they determine the share of any partyat a specific rate tied to the capital. (Usmani, 2002).

2) MUSHARAKAHThe literal meaning of Musharaka is sharing. Musharaka is described as a joint venture betweenan Islamic bank and individual, groups or business entity for a specific project. Both parties in thearrangement participate in the capital of the project and the profit is allocated according to the capitalprovided and predetermined proportion. In the case of loss they are shared by the partners in exactproportion to the ratio of capital invested.

The essential features of Musharaka:

Capital to be invested by the partners may be in equal or unequal ratio. Musharaka is run and managedby the 'will and equal rights of participation' of all partners and every partner is an agent to the other.

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Any condition regarding participation in the administration of Musharaka and variation in theshare of profit is valid.

Every partner has the right to participate actively in the project if he wishes to do so. However, thepartners may agree that only one of them should take care of the project. The basis for entitlement to theprofit of a Musharaka is capital, active participation in the project and responsibility. A partner or ashareholder can be entitled to more profit compared to other partners if he performs more duties andtakes greater responsibility then others. Every partner enjoys equal rights in all respects in the absenceof any condition. If the Musharaka is a longer period than, say one year, up-to-date profit could be paid atan expected rate less a contingency reserve, as interest free loan, subject to periodical adjustments anda final adjustment at the conclusion of the project. (Usmani, 2002, P: 105-106).

Keywords: Islamic Banking, Islamic Banking concept, Abdullah Haiwad, Kandahar, Afghanistan

Working Paper Series

Date posted: October 14, 2008

Suggested CitationHaiwad, Abdullah, Islamic Banking System, Islamic Banking Concept, Islamic Banking, Afghanistan, Kandahar (October 12,2008). Available at SSRN: http://ssrn.com/abstract=1283093