6 July 2002
Alternative Banking Regulation – the Islamic Approach

Assignment (group two)

During last twenty years there has been a rapid development of financial institutions that can be classified as Islamic in that they do not deal in interest-based transactions. The main problem for banking business in Islamic countries is several prohibitions – riba (interest or usury). These prohibitions are prescribed by the Qur’an. Some Suras have mentioned the following: “who will get a recompense multiplied are not of us”, “that they took usury, though they were forbidden”, “who believe! Devour not usury doubled or multiplied, but fear God”, “God will deprive usury of all blessing”, “who believe! Fear God, and give up what remains of your demand for usury, if you are indeed believers”, etc.

In such a way, Islamic banking must be interest-free. Nevertheless, some writers distinguish Islamic banking from interest-free banking, defining Islamic banking as banking in consonance with the ethos and value system of Islam, meanwhile interest-banking, by contrast (sic!), is a narrower concept, denoting a number of banking instruments or operations which avoid interest (1). Any way, the main aim of the Islamic banking is to facilitate economic growth within and according to Islamic principles, which are not allowed payments or receipts of interest by a bank, any engagement in gambling industry, the alcoholic beverage trade, pork meat trade, etc.

Today there are four countries, which implement Islamic, banking at a macro level: Malaysia, Pakistan, Iran and Sudan. All existing bank are relatively new – the oldest having been established in 1973. There are currently five categories of operating Islamic banking:

- The Islamic development Bank, which was established as professional institution to work under Islamic law;

- Those banks which operate in countries where the whole banking system has been converted to operating on Islamic principles and whose activities are overseen in some way by religious bodies (for example, Pakistan);

- Those banks which operate in Muslim countries and which co-exist with interest-based banks (for instance, Jordan, Egypt and Malaysia)’

- Islamic banks in non-Muslim countries, whose monetary authorities do not recognise their Islamic character (for example, the Al-Baraka International Bank in London or the Islamic Banking in Durban, South Africa); and

- Islamic banks which exist in non-Muslim countries whose monetary authorities to recognise their Islamic character (for instance, the Faisal International Bank based in Copenhagen, Denmark, registered under the Danish Banking Supervisory law) (2).

Islamic lawyers and financials, together with religious scientists adopted various techniques to smooth out the controversy between the formal demands of the Shari’a and the economic necessity. Obviously, many Muslim countries are among the least developed countries (LDCs) with a low per capita income. Two problems arise here. Firstly, Due to the low per capita income in these countries, even a fairy high percentage rate of domestic saving yields only a limited amount of new capital. As a result, most LDCs, with exception of oil exporters, have depended on capital inflows from abroad to help finance development. Secondly, many Muslims avoid the banking system because of interest are not given in the Islamic banking, it has been asserted that there is a large number of people outside the banking system (3).

Main element in understanding is how Islamic banking operates with out receiving or paying riba – interest. Islamic banks accept deposits from their clients into different types of accounts: current, saving, general investment and special investment.

Banks accept into current account deposits from the clients looking for custody, and banks can use this money on the principle of trust. Saving accounts are rather similar to current, but banks can, at their own and non-mandatory discretion, reward the clients from time to time by returning a portion of the profits generated from their funds. Islamic banking accept into general accounts deposits from the clients seeking investment opportunities for their funds, on the principle of The deposits are held for a specified period. When operating fully, the Islamic banking intends to accept deposits with different maturities. Finally, special investment accounts, in addition to the general investment facilities for accepting deposits from its ordinary clients, the bank may also selectively accept deposits from its wealthy individual of corporate clients in the form of special investment accounts. Through these accounts, the modes of investment of the funds and the distribution of the profit may be and usually are negotiated individually but also on the principle of mudaraba (4).

Generally speaking, Islamic banks can earn profit in three areas: financing of Profit and Lost sharing Deposits, leasing and trading. Profit and Lost sharing deposits have several forms of implementation. Mudaraba is one of them. It is a partnership of two or more parties (one of them is a bank), when one (or more) party put money in some joint venture (or partnership), and other party (a bank) use these money. Islamic theorists have adopted the conception that banks are not liable for any losses suffered in their investment operations through investment deposits (5). Depositors are to be seemed as equal investors in a mudaraba as bank as. For instance, in Egypt, such operation is provide by an investment account, in which the depositor/investor receives a return proportionate to the bank’s profit (or loss) as a whole on its investment. This is a rudiment of the mudaraba joint venture contract which Islamic law accepts as valid for most Islamic banking operations (6).

Islamic scientists have elaborated also other instruments for banking operations. Thus, murabaha contract, which was developed in recent years, is among them. Under this contract the Islamic financial institutions purchases the goods on behalf of the Muslim client, and the latter agrees to repurchase the goods at a later date with the price adjusted upward by a specified amount (7). And vice versa, sometimes even a customer plays as a bank agent, buying the goods. Such contract allows the importer to obtain credit without riba – interest, until the contractual goods are received by Muslim importer or sold to local client of such importer.

Other form of Muslim client-Islamic bank co-operations is musharaka or sharika, which also form of sui generis partnership. Shari’a law divides these partnerships into two broad categories:

- Property partnership (sharikat mulk), which amounts to the ownership of a property without its joint exploitation, such as the joint ownership of a house transmitted, by devolution, to the heirs of a deceased person,

- Contractual partnership (sharikat ‘aqd), where emphasis is on joint exploitation of capital and the joint participation in profits and losses and where joint ownership is a consequence of, and not a prerequisite for, the formation of the partnership (8).

Nevertheless, many problems can rise during application of Islamic Banking. Some of them have economic and legal character. There are:

- Lack of the conceptual and analytical experience of conventional economics and conventional banking system, such as the theory of supply and demand; implementation of theory and practise in Islamic society,

- Lack of experience entails lack of the data available for analysis, and shortage of specialists,

- Prohibitions of Islam impede to join wide range of international conventions, rules and standard conditions of behaviour and service-providing,

- Lack of legal base, which is often decreased by fiqh or other Islamic sources, etc.

Other problems have religious character. Thus, Islam has various scientific schools among two main doctrines – Sunni and Shia. There are a Hanafi, Maliki, Shafari, Hanbali, Zaydi, Jaffari etc. All schools have different treatments and interpretations of Islamic Banking operation, what impedes to unify and modify Islamic Banking. Besides, almost all Islamic private banks have Religious Supervisory Boards (RSBs). These Boards are given wide powers and authorities to examine any contract, method or activity retailing to the conduct of their banks. The RSB have at their disposal all the means, which are available to the auditors, in order to perform their functions (9). These Boards also can impede to develop banking operations.

All above-mentioned problems adversely affect on the sphere of international trade and money transfer. Islamic banks can offer services in this domain. They establish correspondent relationships with foreign banks to facilitate services to be provided on their behalf. In case of direct money transfers, no special relationship is needed beyond providing the correspondent bank with ready balances in a current account to meet such obligations. The correspondent bank can legitimately claim commission on these services. The Islamic banks may ask the correspondent bank to add its confirmation to letters of credit opened on behalf of foreign suppliers to importers in the country where the Islamic banking operate. Suppliers usually ask for this as an added security for their payment. Either Islamic banks must keep huge surpluses in their account with the correspondent bank to meet such obligations or they must ask the correspondent bank to cover their obligations to the third party (the suppliers) while they seek to replenish their accounts with the correspondent banks.

To solve this problem, in some cases foreign banks agree to deal with Islamic banks on the basis of mutual agreement, initiated and confirmed by a simple exchange of letters, to provide the latter with confirmation facilities up to an agreed ceiling without charging interest. In return for this consideration, Islamic banks undertake to keep a reasonable amount of cash in their current account with the confirming bank and they try to cover any debit as soon as possible (10).

But the new financial instruments are the main problem of collaboration between Islamic banks and conventional banks. Islamic theorists did not elaborate yet the principles of implementation and treatment of forfeit, REPO and DEPO transactions, precious metal accounts, etc. Conventional banking development is much faster than Islamic one, because strict interpretation of Islamic provisions limits the range of valid transaction.

1. Al-Omar/Abdel Haq “Islamic banking”, chapter 2 “Overview of Islamic banking”, pg. 21, (citing Masri, 1981), 2-d Books, 1996.
2. Al-Omar/Abdel Haq “Islamic banking”, chapter 2 “Overview of Islamic banking”, pg. 22, 2-d Books, 1996.
3. A. Saud. “Islamic banking and interest”, Chapter 6, pp. 96-97, Bill, 1996, (citing Dolan. “Macro-Economics”, pp. 539-40. And Abdeen and Shook, “The Saudi financial system”, pg.181.)
4. Al-Omar/Abdel “Islamic banking”, chapter 2 “Overview of Islamic banking”, pp. 30-31, 2-d Books, 1996. (citing Ismail, 1992).
5. A. Saud. “Islamic banking and interest”, Chapter 6 “Deposits and Depositors”, pp. 101, Bill, 1996.
6. I.D. Edge “Shari’a and commerce in contemporary Egypt”, pg.43, “Islamic Law and Finance”, edited Mallat, GAT, 1988.
7. R. Wilson, “Islamic Financial instrument”, “Arab Law Quarterly”, “GHQ”, 1991, pg. 211.
8. N.A. Saleh, “Unlawful gain and legitimate profit In Islamic law” Chapter 4, “A Financial System based on Islamic Ethics” pg. 113, G&T, 1992.
9. A. Saud. “Islamic banking and interest”, Chapter 7 “Religious Supervisory Boards and Islamic Banking”, pp. 108, Bill, 1996
10. Al-Omar/Abdel “Islamic banking”, chapter 2 “Overview of Islamic banking”, pg. 32, 2-d Books, 1996.

Bibliography

1. Al-Omar/Abdel Haq “Islamic banking”, 2-d Books, 1996.

2. A. Saud. “Islamic banking and interest”, 101, Bill, 1996.

3. I.D. Edge “Shari’a and commerce in contemporary Egypt”, “Islamic Law and Finance”, edited Mallat, GAT, 1988.

4. R. Wilson, “Islamic Financial instrument”, “Arab Law Quarterly”, “GHQ”, 1991.

5. N.A. Saleh, “Unlawful gain and legitimate profit In Islamic law”, G&T, 1992.