ISLAMIC

FINANCE AND
BANKING SYSTEM
Philosophies, Principles & Practices

Sudin Haron
Wan Nursofiza Wan Azmi
 FOREWORD

In an increasingly challenging global financial environment that

continues to be punctuated by crisis, Islamic finance has continued
to remain robust as a viable form of financial intermediation. The
transformation and progressive pace of development of Islamic
finance is now gaining an international dimension as it becomes
an increasingly important component of the international financial
system. These developments have been a catalyst for increased
financial innovation and participation in the Islamic financial
markets.
Malaysia's experience in developing a comprehensive Islamic
financial system has brought the country to the forefront in the
development and evolution of the industry. An important aspect
of this is that the development by the industry is supported by a
sound regulatory structure that is in place to ensure the soundness
and stability of the system. This has attracted major Islamic financial
services players to the country. The Islamic financial system in
Malaysia is noiv regarded as one of the most comprehensive in the
world.
The sustainable growth and competitiveness of the Islamic
finance industry however depends essentially on human intellectual
capital development and the investment in research. There is
an urgent need to produce highly qualified professionals in this
area so as to ensure continued innovation of new products and
services to meet the diverse needs of the economy. The task before
us now is how to meet the challenging demand for world-class
professionals in Islamic finance who are proficient in both technical
and Shariah aspects of the subject matter. Strong focus on human
capital development through education is the key. Since, there are

iii
iv FOREWORD

still many areas of Islamic finance that have yet to be explored,

new research findings could pave the way towards the broadening
and deepening of the Islamic financial markets and subsequently
strengthening the industry's development.
The publication of thisbook on Islamic Financeand Banking System
that focuses on theoretical, conceptual and operational aspects,
laws and regulations of Islamic banking, Islamic financial markets,
takaful system is indeed an important initiative. The information
on the relevant areas related to Islamic finance in this book will
be valuable to those who wish to gain a greater understanding on
Islamic finance. I sincerely hope that the publication of this book
will contribute towards greater understanding in the fundamental
aspects of Islamic finance. A better understanding will certainly
increase awareness of Islamic finance and the tremendous potential
it offers as a form of financial intermediation in our global financial
system.

Dr. Zeti Akhtar Aziz

Governor
Bank Negara Malaysia
 PREFACE

Islamic banking which began as a theological dream has today

become a practical reality and accepted worldwide. Islamic
banking and finance has transformed from an infant industry in
the 1970s to one of the most viable and efficient alternative models
of financial intermediation. The Islamic financial services industry
has consistently chalked up double-digit growth with a presence in
more than 75 countries. It is estimated that total financial assets of
the industry now exceed US$1 trillion.
The integration of Islamic finance into the global economy is
marked by the growing awareness of and demand for investing
in accordance with Syariah principles, progress in developing
regulatory framework and enhanced international linkages.
However, the successof Islamic banking brings forth new challenges
to the industry. These include lack of standard financial contracts
and products, illiquidity issues, liquidity risk management concerns,
regulatory disparities among regulators at the national level and
the need for harmonized regulation.
These successes and challenges facing Islamic financial
institutions have been widely documented. Nonetheless, there
is still an acute dearth of literature which covers concepts and
applications of Islamic banking worldwide as well as provides
comprehensive illustration of all major aspects of Islamic finance
and banking on a more global scale. Having kept a close watch
on developments in Islamic finance and banking over the last two
decades and excessive work done on the subject, we wanted to
contribute in addressing this gap in the literature.
This book is an effort to provide a comprehensive knowledge on
Islamic finance and to highlight current development of the industry
worldwide. The first four chapters set the tone for the rest of the
VI PREFACE

book. Readers are introduced to the history and development of

Islamic banking and are provided with in-depth discussion on the
theoretical and conceptual aspects of Islamic banking. The next four
chapters cover Islamic banking, takafiil and Islamic capital market
which have all experienced accelerated growth due to increased
diversification in investment. The last chapter features the role and
development of special organizations related to the Islamic financial
system. We have also attempted to give readers an overview of
various Islamic banking and financial models as practised in other
countries. However, the primary strength of this book lies in its
comprehensive and contemporary approach in discussing Islamic
finance and banking by covering all the relevant areas.
The recent financial crisis that has emerged due to global credit
woes has broaden the appeal of Islamic finance. The global credit
crisis has shown the need for laws enshrined in Islamic finance which
prohibit speculation and high levels of debt and promote high level
of financial prudence. Syariah also prohibits immoral transactions
and encourages greater social justice through the sharing of risk
and rewards and socially responsible investments. It is these ethical
and moral safeguards that are missing in the conventional system.
As the world is looking for a new economic order amid the current
financial woes, Islamic finance is presented with a great opportunity
to step up to the mark and gain traction. It is our sincere hope
that this book will contribute to a better understanding of Islamic
finance and banking and the role it can play in filling the liquidity
gap under the new economic order.
This book is not our venture alone. We extend special thanks to
our families and friends for their support and encouragement. We
also appreciate the invaluable comments of the reviewers on the
draft of the book. Finally, we accept responsibility' for any errors,
omissions and shortcomings that remain.

Sudin Haron
Wan Nursofiza Wan Azmi
 CONTENTS

FOREWORD iii
PREFACE v

CHAPTER 1: FUNDAMENTALS OF ISLAMIC ECONOMIC

SYSTEM 1
Introduction 1
Definition of Economics 2
World Economic System 6
Islamic Economic System 14
Islamic Economic Methodology 18
The Essence of Islamic Economics

g «
Fundamentals of Islamic Economic Law

S
Summary
References and Further Reading
$
CHAPTER 2: HISTORY AND DEVELOPMENT OF THE
£ &
ISLAMIC BANKING SYSTEM
Introduction
History of Islamic Banking
S fe

Early era of Islamic banking system

Middle era of Islamic banking system
Era of modem Islamic banking
8

Development of Islamic Banking System in Selected

d 3 2 8 2

Countries
History of Islamic banking system in Egypt
History of Islamic banking system in Sudan
History of Islamic banking system in Turkey
History of Islamic banking system in Malaysia

vii
Viii CONTENTS

History of Islamic banking system in Iran 80

History of Islamic banking system in Pakistan 82
Summary 86
References and Further Reading 87

CHAPTER 3: OBJECTIVES, PHILOSOPHY AND PRINCIPLES

OF ISLAMIC BANKING 93
Introduction 93
Objectives of Establishment and Business Philosophy
of Islamic Banks 95
Social Practices of the World's Islamic Banks 110
Factors that Influence the Formation of the Philosophy
of Islamic Banks 114
Sources of Islamic Banking Philosophy 120
The Essence of the Business Philosophy of
Islamic Banks 121
Operational Principles of Islamic Banks 128
The musyarakah principle 130
The niinJItnrabnh principle 131
The niurabaha/t principle 134
The ijarah principle 136
The ijaril liassan principle 138
The wadiah principle 139
Tlie rahii principle 140
Other principles 141
Priorities in the Use of Synrialt Principles 145
Sources and Uses of Funds 147
Relationship Between Islamic Banks and
Their Customers 150
Relationship with suppliers of funds 151
Relationship with users of funds 155
Summary 157
References and Further Reading 159
 CONTRNTS i«

CHAPTER 4: THE CONCEPTS OF INTEREST,

USURY AND RIBA 163
Introduction 163
Definitions of Interest, Usur^ and Riba 165
Concepts of Interest and Usury from the Non-muslim
Perspective 170
The concept of interest among the Jews 172
The concept of interest among the Greeks and Roman 174
The concept of interest among Christians 178
Views of the early Christian priests 179
Views of scholars 181
Views of reformists 183
Tiie Concept of Riba from the Islamic Perspective 185
Prohibition against riba 186
Prohibition against riba by the Quran 187
Prohibition against riba by the Hadiih 192
Classification of riba 198
Riba among Muslims 203
Views of the mazhab on riba 204
Views of modern scholars 210
Summary 214
References and Further Reading 216

CHAPTER 5: LAWS AND REGULATIONS OF

ISLAMIC BANKING 221
Introduction 221
The Concept and Meaning of Syariah 224
Sources of Syariah 227
The first source: The Quran 228
The second source: Hadith 232
The third source: ljma 239
The fourth source: Qiyas 241
General Laws of Syariah in Islamic Banking System 244
X CONTENTS

Specific Syariah Laws Related to Islamic

Banking System 249
Positive Laws and Regulations 253
Involvement of the central bank 260
Syariah Supervisory Committee 269
Summary 277
References and Further Reading 280

CHAPTER 6: OPERATIONAL ASPECTS AND PRACTICES

OF ISLAMIC BANKING SYSTEM 285
Introduction 285
Application of Syariah Principles 288
Services Provided by Islamic Banks 296
Deposit facilities 297
Financing facilities 300
Other facilities 308
Sources of Funds 315
Uses of Funds 318
Social and Welfare Activities 323
Accounting Policies 327
The basis of financial statement preparation 330
Revenue recognition 331
Investment 339
Provision for doubtful debts 342
Fixed assets and depreciation 344
Allocation of profit 347
Payment of zakat 347
Ollier policies 348
Risk Management 349
Summary 353
References and Further Reading 355

CHAPTER 7: ISLAMIC FINANCIAL MARKETS 359

Introduction 359
 CONTENTS XI

Types of Financial Market 361

Capital market 361
Money market 375
Forward and future markets ' 378
Mortgage market 380
Unit trust market 383
Islamic Financial Market Practices in Malaysia 386
Government Investment Issue 387
Bank Negara Negotiable Notes 389
Short-term trade bills 390
Islamic negotiable instruments of deposit 392
Mudharabah Inter-bank Investment 391
Bonds based on bai bithainan ajil and murabahah principles 394
Bonds without coupon value based on mumbahah and
bai al-inah principles 397
Bonds based on ijarah principle 401
Bonds based on Cagamas Mudharabah 409
Organizations Associated with Islamic Financial Market 410
Securities Commission 414
Summary 418
References and Further Reading 420

CHAPTER 8: ISLAMIC INSURANCE SYSTEM 423

Introduction 423
Background of the Conventional Insurance System 425
History and Development of the Islamic Insurance
System 431
Philosophy, Principle and Operational Concept
of Takaful 437
The takaful principle 438
Operational concept 442
Types of Takaful Cover 444
Family takaful 444
General takaful 447
xii CONTENTS

Implementation Method of Takaful System 448

Implementation of general takaful 448
Implementation of family takaful 452
Summary 455
References and Further Reading 457

CHAPTER 9: ORGANIZATIONS RELATED TO

THE ISLAMIC BANKING SYSTEM 459
Introduction 459
Islamic Development Bank 463
Project financing, technical assistance and Waqf fund
operations (special assistance) 468
Trade financing operations 478
Activities of specialized funds and affiliated institutions 482
Accounting and Auditing Organization for Islamic
Financial Institutions 487
General Council for Islamic Banks and Financial
Institutions 491
International Islamic Financial Market 493
Islamic Financial Services Board 497
Association of Islamic Banking Institutions Malaysia 500
Islamic Banking and Finance Institute Malaysia 501
Summary 502
References and Further Reading 504

GLOSSARY 505

INDEX
 CHAPTER

FUNDAMENTALS OF
ISLAMIC ECONOMIC SYSTEM

This chapter gives a brief description of matters relating to existing

economic systems practised throughout the world. This basic knowledge is
essential for anyone who wishes to learn all aspects of Islamic economics.
The chapter then covers the concepts and essence of the development of the
Islamic economic system of which Islamic banking is a branch.

INTRODUCTION

Efforts to instil Islamic ideas and values into the field of economics
only started not more than three decades ago. that is, in the 1970s
(Siddiqi, 1996). If we accept this view, it implies that Islamic
economic system did not exist before that time. Certainly this is
not true; in fact it is even absurd. This is because Islamic economic
system had existed alongside Islam. Perhaps Siddiqi was actually
referring to the re-absorption process of Islamic principles into the
field of economics. The existence of Islamic economics is proven
through Surah al-Maidah. where Allah (s.w.t.) says:
2 CHAPTER 1

... This day I have perfected your religion for you. completed myfavour
upon you, and have chosen for you Islam as your religion... (Q5: 3)

Based on the above verse, it is clear that Islam encompasses all

aspects of the human life. This being so, it follows that Islam has
its own unique system of economy (Chapra, 1994). The Prophet
Muhammad (p.b.u.h.) in his youth practised and implemented
this system of economy through trade based on the concept of
mudharahah with his wifeSiti Khadijah. In fact, He participated in all
activities involving the development and implementation of Islamic
economics. As an example, one of the early concepts of economics
in Islam can be found in the method of distributing wealth obtained
from battles won. Such Islamic economic activities continued to
be developed after the time of the Prophet (p.b.u.h.), During the
era of Caliph Omar al-Khattab (634-644), for instance, a great
deal was done in the coordination and introduction of economic
activities for the good of the Islamic ummah, or Muslims, which
was consequently adopted by many other parties. Unfortunately,
these concepts of Islamic economics were not really made known
and some were even forgotten. Instead, Muslims were exposed
to economic systems established and developed by non-Muslim
intellectuals. As a result, society was led or forced to learn about
the economic systems of the West, and consequently became more
familiar with capitalist, socialist and marxist economics.

DEFINITION OF ECONOMICS

Barnhart (1988) defined economy or yconomyc as management of

the household. The word economy was first used in the year 1440
and may have originated from a word in the mid-French era, that is
economic, or from the Latin oeconomia, or from the Creek oikonomia
(which comes from the word oikonomos meaning manager or guard).
 f VNDAMEN1 AI.S OF ISLAMIC ECONOMIC SYSTEM 3

The use of this word to mean management of a nation’s resources

was adopted in the year 1651.
The history of modem economics began in 1776 when Adam
Smith published his book called, An Inquiry into the Nature and
Causes of the Wealth of Nations which described the principles
in a market economy. In his other book. The Wealth of Nations,
Smith discussed matters relating to determining the price of a
commodity; determining the price of land, labour and capital; and
the strengths and weaknesses of the market mechanisms. All the
ideas and concepts put forward by Adam Smith are still in use
today. However, Smith only offered the concept of microeconomics,
which is one of the two branches of economics, the other being
macroeconomics. Microeconomics is the analysis of individual
behaviour in economics, such as determining the price of a certain
commodity in the market, or the behaviour of a particular person
or a particular firm.
The concept of macroeconomics was introduced in the year
1936 bv John Maynard Keynes. The field of macroeconomics covers
aspects related to production, income, price level, international
trade, unemployment and the work force as a whole. In his book
titled The General Theory of Employment. Interest, and Money. Keynes
discussed factors which stimulate economic crises, determinants of
investment, the role of central banks in managing money and interest
rates and why some nations develop rapidly while others remain
static. Keynes also explained the importance of the role played by
governments in evening out the fluctuations of the business cycle
(Samuelson and Nordhaus, 1995). I lence, the concepts introduced
by Keynes included banking and financial concepts. The concepts
of Islamic finance and banking need to be looked at by making
comparisons with the macroeconomic concepts offered by this
Western intellectual.
Apart from this, there are various definitions of economics
put forward by intellectuals. Low and Toh (1997) listed several
definitions given by renowned economics intellectuals as follows:
4 CIIArrr.K 1

1. Adam Smith: Economics or political economics is the study of

the natural world and the causes of the wealth of nations.

2. Naasau William Sr.: Political economics is the science related

to the natural world, and the production and distribution of
wealth.
3. Alfred Marshall: Political economics or economics is the study
of the everyday lives of people, where a part of it is about
wealth, while the other part, which is most important, is about
man himself.

4. Lionel Robbins: Economics is the science that studies the

behaviour of man as a correlation between objectives and
limited capacity of multiple uses.

5. Milton Friedman: Economics is the science that studies the

methods used by particular societies to solve their economic
problems.

6. Richard Lipsey, Peter Steiner, Douglas Purvis and Paul Courant:

Economics is the study of the use of limited resources to meet
unlimited demands.

7. Paul Samuelson and William S. Nordhaus: Economics is the

study of the use of limited resources to produce valuable
commodities and distribute them to different people.

8. Rupert Pcnnant-Rea and Bill Emmott: Economics is something

which is difficult to define, but most people would recognize it
when they see it. In general, economics is the study of the ways
societies of the world live their lives. In more specific terms,
economics is the study of the ways in which limited resources
are used to produce and distribute products and services to
meet the needs of people.

The various definitions of economies given by the intellectuals were

summarized by Samuelson and Nordhaus (1995). They summed
up economics as the science that:
 FVNDAMENIALS OF ISLAMIC ECONOMIC SYSTEM 5

1. Studies methods of determining the cost of labour, capital and

land and ways in which the costing is used for the purposes of
resource distribution.

2. Explores the behaviour of the financial market and analyzes the

method of capital distribution to the economy as a whole.
3. Analyzes the existing effects on market efficiency resulting from
regulations imposed by governments.

4. Studies income distribution and suggests ways to provide

assistance to the poor without harming economic performance.
5. Examines the effects of government expenditure, taxation and
budget deficit on economic development.
6. Examines the increase or decline in labour consumption and
production which creates the business cycle, and establishes
government policies to enhance economic growth.
7. Examines inter-nation forms of trade and analyzes effects of
trade embargoes.

8. Studies economic growth in developing nations and suggests

methods to promote effective use of resources.

Kanins Ekonomi (1993) defined economics as a field of social science

that studies the behaviour of humans in the provision of limited
resources to meet unlimited needs and demands, where one
competes with the other.
Almost all the above definitions of economics revolve around
the problem faced by society in making choices to meet unlimited
needs based on limited resources. The limited resources must be
used in the most effective way so as to benefit the whole of society,
and distribution has to be based on efforts put in. Hence, Niemi
(1978) defined economics as a study of ways in which society makes
choices when distributing limited resources to meet unlimited
demands such that society benefits fully and that the benefit
obtained is in accordance with their contribution.
6 ciurTEK 1

The resources referred to relate to human and physical resources.

Human resource, also known as the labour factor, includes
management and entrepreneurship elements. Labour is the work
force that moves an economy and it can be seen as two groups, one
comprising the thinkers and managers and the other comprising
the workers who implement the tasks as directed. The physical
resource is made up of land and capital factors. These factors are
also called factors of production. In this situation, the operator
works to produce g<x>ds with the hope of receiving returns after
the product or service is utilized by the consumer. The operator
would put in every' effort to fully utilize all factors of production,
while the consumer would make choices such that tire product he
buys would meet his needs as much as possible and is worth the
money spent in acquiring it.

WORLD ECONOMIC SYSTEM

According to Gregory and Stuart (1999). the economic sy stem is

a set of mechanisms and institutions that makes and implements
decisions related to the production, income and consumption
in a particular region or area. Hence, an economic system is the
interaction among participants involved in an organization,
according to the regulations and instructions, in the production,
distribution and consumption of products and services. An
economic system can also be viewed as a regulation whereby
society will determine what will be produced, how the product
will be produced (this includes matters relating to the institution or
organization, the equipment used, as well as the form of resources
that are distributed) and how the income obtained from the sale of
the products and services is distributed to the masses (Bronstein,
1994). In order to make comparisons of the different economic
systems, a fundamental basis which can be used as a measure of the
 FUNDAMENTALS OF ISLAMIC ECONOMIC SYSTEM 7

differences has to be established. Bronstein asserted that there are

three factors that influence the formation of an economic system,
namely the level of economic development, social and cultural
factors, and environment. z
Gregory and Stuart ( 1999) described four main characteristics that
d istinguish one economic system from another. The first characteristic
is associated with the way decisions are made. The second is related
to the mechanism for the provision of information and coordination
of decisions. The third is about property rights. Finally, the fourth
covers mechanism in preparing goals and incentives for the masses
to execute a particular action.
The main characteristic, that is the issue of the organization
of decision-making arrangements, involves aspects associated
with methods and processes of decision making practised by
organizations or economic agents including governments.
Organizations in a society are normally made up of members who
constantly interact among one another in carrying out an activity. An
organization would have goals from which information would be
developed, while assumptionsand behaviour would be formulated.
All these have roles to play in arriving at particular decisions. Since
an organization comprises many members, contradictions are
bound to exist between individual and organizational goals. To
overcome this problem, an organization establishes rules related
to the formation of small groups, work distribution, coordination
and monitoring of activities as well as explanation of the incentives
offered. All the rules and regulations which are formulated and
established will determine the structure of an organization, which
will in turn become the basis that distinguishes one economic
system from another. Organizational structure can be viewed from
two different perspectives.
The first perspective is based on the way a particular activity is
implemented. Organizations in this category fall into two types, one
based on hierarchy and the other, association. Under the hierarchy
type of organization, decisions are made by the higher-ups, while
8 CHAPTER 1

(he rank and file merely implement the decisions and instructions
to achieve the goals set. Under the association type of organization,
decisions are made collectively bv members, there being no
relationship between the leaders and the workers. The second
perspective involves the way in which distribution of resources
is decided upon. Organizations in this category are classed as
non-centred and centred organizations. In non-centred
organizations decisions are made at the lower levels, while in centred
organizations centralized decisions are made at the top levels.
The second characteristic, related to the mechanism of the
provision of information and coordination of decisions, refers
to two forms of economy, namely planned economy and market
economy. In planned economy, all agents are coordinated by way
of set instructions which are documented and established by the
central agency. The agent is required to implement all instructions
alongside incentives and restrictions given by the authorities who
prepare the plan. Returns received by implementers will depend on
their achievements of given instructions. In market economy, on the
other hand, an organization decides on the use of resources based
on the forces of supply and demand. This means that the market
situation will coordinate the decision-making process of economic
units. The main thing that differentiates a planned economic
system from a market economy is the decision maker. In market
economy, clients can exercise their right to choose, and their right to
use whatever they wish. On the other hand, in a planned economic
system, it is the planner who determines production activities and
the products to be produced. In this case, the priority of the planner
overrules priority of the masses,
The third characteristic that differentiates economic systems is
property ownership rights in society. Property ownership rights are
of three types: first, the right to transfer ownership, which involves
giving, transferring or selling property to another party; secondly, the
right to use the property, and thirdly, the right to use whatever that is
produced from the property held. Property ownership may also be
 FUNDAMENTALS OF ISLAMIC ECONOMIC SYSTEM 9

categorized into three main forms: individual or private ownership,

public ownership and joint ownership. In private ownership, all
three types of ownership rights are provided to the individual. In
public ownership, however, those rights are held by the nation.
The fourth characteristic which differentiates economic systems
is the way incentives are given to society to regulate economic
activities. An incentive is an instrument which can be used to
encourage or motivate people to do something. Normally, the
authorities may offer two kinds of incentives, that is, material
incentive and moral incentive. Material incentive is common in
the current economic system, and it can be divided into private
incentive and collective incentive. Collective material incentive is
given with the intention of promoting a sense of social consciousness
and solidarity, while private incentive encourages competition and
individualism. Moral incentive motivates the receiver to be more
responsible towards society so as to attain a high position. This
kind of incentive does not involve tangible gain for the receiver.
Based on the explanation of the four characteristics, the
economic systems of the world can be divided into several main
clusters. The most frequently used clusters are capitalism and
socialism. There are many theories that relate to these economic-
systems. However, those theories will not be discussed in detail
in this book. Capitalism is an economic system characterized by
individual ownership of factors of production. The process of
decision making lies in the hands of the owner of the factors of
production and the decision made is based on or coordinated by
market mechanisms. The market becomes the place for owners
to obtain information, and material incentives become the
motivation for the people. This method was pioneered by Adam
Smith in his book, The Wealth of Nations in 1776. According to him,
the most efficient economic system exists when there are market
competition and no government intervention in the economy.
There are various kinds of capitalism in the world. Schnitzer (1994)
in his book, Comparative Economic Systems, divided capitalism into
10 CltAFTlsK 1

twoclasses, individual capitalism and social capitalism. Individual

capitalism system is commonly called market economic system or
open economic system, while social capitalism is normally known
as the system of mixed economy.
Individual capitalism is a system practised by Anglo-Saxon
nations. In the 19th century, the United Kingdom was the leading
nation implementing the system, while in the 20th century it was the
United States that led. Social capitalism, meanwhile, has become the
practice of European countries like Germany and nations in the East
such as Japan and South East Asia. In this system, the government
plays an important role in promoting economic development and
providing welfare services to the society. Through this system,
employers are more loyal to their workplace and the company
cooperates in planning strategies for mutual benefit. In other
words, in the capitalist system there is smart partnership between
the government and the private sectors.
There are various differing concepts and definitions for the
socialist system. For instance, there exist differences in the socialist
concept as practised in France and several Eastern European
nations compared to that in nations like the former Soviet Union,
China, Cuba, North Korea and Vietnam. The West is of the opinion
that nations under communist regimes, like Russia, China, Cuba,
North Korea and Vietnam are not socialist countries, but are
instead nations that practise communism. The words socialist
and socialism are said to be relatively new and were introduced
in England and France in the early 19th century. However, the
concept had already been mentioned by philosophers, right
from the time of Plato (427-347BC). In fact, a Christian thinker.
Thomas Aquinas (1225-1274) held the view that property could
be owned by individual but its use should be for all (Schnitzel)
1994). During the Renaissance period (that is, a period of great
cultural change in Europe that spanned from the 14th to the 17th
century) many intellectuals discussed the kind of society that they
would like to see created. The majority of them wanted a utopia
 FUNDAMENTALS OF ISLAMIC ECONOMIC SYSTEM II

kind of society, that is, a society which has a perfect social system,
which creates social happiness, whereby the principal entities
in this situation are economic and social factors, not religion.
Utopic socialism is based on th<> theory that the existence of the
world is meant to provide joy and happiness to the people, and
that each human being has a natural right to it (Fly, 1983).
Modern socialist system is a system that was developed
as a social reformation due to the brutalities triggered by the
industrial revolution which began in England in the middle of
the 11th century. The term industrial revolution means changing
from traditional society to modem society through economic
industrialization. Robert Owen, an English socialist, is said to
have started the modern socialist era in 1800 when he created
the social change scheme by altering the beliefs of individual.
He believed that true happiness is attained by making others
happy (Schnitzer, 1994). Socialism began to spread to the
political system of England by the middle of the 19th century.
Large-scale retrenchment of workers due to an economic
depression became the main factor for the development of this
ideology. This movement subsequently received support from
trade unions and intellectuals who believed that political and
economic structures should be changed for the good of the workers.
Socialism began to spread as a political movement at the end of the
19th century, whereby political parties based on this ideology were
established in France and Germany in 1900. As with the capitalist
system, there are many variations of the socialist system.
Gregory and Stuart (1999) divided socialism into two groups,
market socialism and planned socialism. Market socialism is
characterized by public(national)ownershipoffactorsof production,
and decisions are not made centrally, but instead a decentralized
process based on market mechanisms is used. Material and moral
elements are used as incentives to motivate people. In planned
socialism, on the other hand, there is also public ownership of the
factors of production, but decisions are made at the central level.
12 CHAPTER 1

Planners at this level will issue instructions to be followed by those

in the system, and both material and moral incentives are used to
motivate the people.
There is also classification in socialism, based on the Marxist
and non-Marxist ideologies. Marxists believe that revolution is
necessary in order to establish the socialist ideology. The non-Marxist
group, on the other hand, is of the stand that changes could be
made to the existing economic, political and social systems without
any revolution. The Marxist socialist system was pioneered by
Karl Marx (1818-1883), who viewed that the transformation from
capitalism to communism was inevitable. Capitalism exploited
workers and caused friction in an organization. Hence, the system
should be replaced with socialism in which the concept of common
ownership was given importance.
The communist system is at the tail end of the socialist
system, and is characterized by the absence of market and money.
Distribution of necessities depends on needs. This basic concept of
communism was discussed by the Greek philosopher Plato in his
book, Republic. Plato was of the opinion that a perfect nation is one
with communist societies, where everything is collectively owned,
at least for the upper classes. The upper classes that rule and control
the nation would eat in the same hall and sleep in the same building
as the common people, and would even obtain aid from them.
Marx's views on socialism are found in his book, Dns Kapital.
In this book, Marx wrote his economic theory which forms the
basis of the communist ideology. Marx’s emphasis on the crucial
importance of the role played by the government or nation
was reinforced by V.I. Lenin (1870-1924). Lenin was one of the
greatest revolutionary thinkers of the 20th century. He believed
that inequality and capitalist attributes still existed in socialism;
hence, stem action on the part of the government was necessary.
However. Marx and Lenin merely offered views about the role of
the nation and ways to distribute income in socialism. They did not
discuss methods of distributing limited resources.
 FUNDAMENTALS Or ISLAMIC ECONOMIC SVSTF.M 13

While Karl Marx is regarded as the one who initiated modem

communism, Lenin is viewed as the one who developed the ideology.
Through the Bolshevick Revolution in 1917, Lenin successfully
established the Soviet Union and subsequently the Communist
Party in March 1918. The Soviet nation and the communist
ideology continued to be upheld by several leaders such as Joseph
Stalin who ruled from 1924 to 1953, Nikita Khrushchev from 1953
to 1964 and Leonid Brezhnev from 1964 to 1982. The influence of
communism developed further with the end of the Second World
War, and began to spread to Eastern Europe, China, North Korea,
Cuba and Vietnam. During its peak period, almost one-third of the
world population were living in nations that practised this system.
The communist system, whose origin and reference was the
Soviet Union, moved into a transition period beginning in 1985
when Mikhail Gorbachev came to power. Gorbachev introduced
radical reformations to the economic, political and societal
structures. Eventually, it was the reformation itself which caused
the disintegration of the Soviet Union and which saw the end
of communism in the Soviet Union. Gorbachev introduced the
prestroika concept (which means restructuring), the^Zasiiosf concept
(which means openness in public affairs) and the democratization
concept (a concept that takes into account the views of those in the
lower ranks).
The break-up of the Soviet Union which consisted of 15 separate
republics began when 3 of the republics, namely Estonia, Latvia
and Lithuania declared their respective independence in 1990.
In 1991, there was an attempt by ardent believers of communism
to seize power and overthrow Gorbachev. Although the attempt
failed, Gorbachev lost his power and was forced to resign, and as a
consequence the structure of the Communist Party crumbled. This
opportunity was used by Boris Yeltsin, the President of the Russian
Union, to replace Gorbachev as the leader of the Soviet Union.
However, during this time the nations in the Soviet Union began
to declare their respective independence and took over properties
14 CHATTER I

belonging to the Soviet Union in their respective countries. In

December 1991, 3 main republics in the Soviet Union, namely
Russia, Ukraine and Belarus agreed to establish theCommonw'calth
of Independent States, and on 21 December 1991 eight former
Soviet nations agreed to rejoin the Union. With that came the end
of the Soviet Union (Schnitzer, 1994).
The changes executed by the Soviet rulers serve as an example
for other communist nations, l’olitical change also occurred in the
Eastern European nations which were ruled by communists, such
as East Germany, Czechoslovakia, Bulgaria, Poland and Hungary.
Such changes normally occurred in two phases. In the first phase,
the communist rule was replaced by communist reformists who
were prepared to share power with non-communist groups, and
eventually eroded the monopoly power of the communist party.
In the second phase, non-communists were chosen to replace the
government, with the hope that the ruling party would cooperate
with the West and establish a market economy. To date, other
communist nations like China, Vietnam, North Korea and Cuba
have also started the process of business relationships with the
West, and in certain cases have allowed the establishment of market
economy in their respective nations.

ISLAMIC ECONOMIC SYSTEM

Based on the definitions of economy and economics given in the

early part of this chapter, it can be concluded that economics is a
branch of knowledge about the ways people use existing resources
to create products and services for their use. The Islamic ummah
or Muslims are people who work to obtain rezcki (sustenance) by
using the resources made available by Allah (s.w.t.) for their use
while living in this world and as preparation for the Hereafter. This
fact shows that there must exist knowledge related to economy in
 FUNDAMENTALS OF ISLAMIC ECONOMIC SYSTEM 15

Islam. There are many examples in the verses of the Quran which
relate to economy. Apart from that, there are many Hadith that carry
guidelines, views and lessons on aspects relating to economy given
by the Prophet (p.b.u.h.). In fact, Allah (s.w.t.) mentioned economic
matters related to the days of the earlier prophets. For example, the
following two verses describe economic matters during the time of
Abraham and Shu’avb:

And We made them leaders, xuiding men by Our command, and We

sent them an inspiration Io do good deeds, to establish regular prayers,
and to practise regular charity; and they constantly served Us (and
Us only). (Q21:73)

Give just measure, and cause no loss (to others by fraud). And weigh
with scales true and upright. And withhold not things justly due to
men, nor do evil in the land, working mischief. (Q26:181-183)

Apart from the above verses there are many other verses presented
by Allah (s.w.t.) in the Quran that are of relevance to economy.
Furthermore, the Prophet Muhammad (p.b.u.h.) in his Hadith,
frequently discussed issues of economy and business.
From the explanation above, it is clear that the religion of Islam
is not merely about the relationship between human beings and
their Creator, but it also covers the ways humans are to manage
existing resources on earth in line with the reason and intent of
them being made available. The following verses explain this:

It is He who hath createdfor you all things that are on earth; moreover
His design comprehended the heavens,for He gave order and perfection
to the seven firmaments; and ofall things He has perfect knowledge.
(Q2: 29)

It is He who has made the sea subject, that ye may eat thereofflesh that
is fresh and tender, and that ye may extract therefrom ornaments to
wear, and thou sees! the ships therein that plough the waves, that ye
may seek (thus) of the bounty of Allah and that ye may be gratefid.
(Q16: 14; see also Q30:46; Q35: 12; and Q45: 12)
16 CHATTER 1

Say: Who has forbidden the beautiful (gifts) of Allah, which He hath
produced for His servants, and the things, clean and pure, (which He
hath provided) for sustenance? Say: They are, in the life of this world,
for those who believe, (and) purely for them on the Day of Judgement.
Thus do We explain the Signs in detail for those who understand.
(Q7:32)

It is evident that Islam is not a religion that places importance solely

on the Hereafter, but also on worldly affairs. However, Islamic
economic knowledge was not developed and passed down from
generation to generation. In fact, what is even more disheartening is
the fact that the fundamental substance of economics claimed to have
been developed by intellectuals from the West was in fact stolen from
the works of great thinkers of Islamic economics. Islamic scholars
who conducted various researches discovered that there are a lot of
similarities between the views presented by Western intellectuals
and the views of Islamic thinkers who had lived in much earlier
times. Listed below arc some of such views (Karim, 2002):

(i) The optima pareto theory originated from the works of Imam
Ali r.a. titled Nahjul Balagh.

(ii) Priest Bar I lebraeus from the Syariac Jacobite church copied
several chapters from the book Ihya Ulumuddin written by
Imam Ghazali.

(iii) Priest Raymond Martini from the Spain Ordo Dominican

church copied many chapters from the books of Tahafata
al-Talasifa, Maqasida al-Falasifit, Al-Munaqid. Misykat Al-Anwar
and Iliya Ulumuddin written by Imam Ghazali.

(iv) St. Thomas Aquinas plagiarized many chapters from the works
of al-Farabi.

(v) Writings of Adam Smith in the book The Wealth ofNations (1776)
shared a lot of similarities with the works of Abu L'bayad
(d. 838 A.C.) titled al-Amwal or The Wealth.
 FUNDAMENTALS OF ISl AMIC ECONOMIC SYSTEM 17

Apart from the works of early Islamic thinkers of economics which

were copied by Western intellectuals, there exist many more works
related to economics produced by Islamic thinkers and scholars.
According to Karim (2002), some/of the works on economics by
early Islamic thinkers are:

(i) Risala al-Sliahabah by Abdullah bin al-Muqaffa (109-145 H /

727-762), works on policies and public financial administration.

(ii) Kitab al-Kharaj by Abu Yusuf (113-182 H / 731-789), works on

financial management.

(iii) Kitab al-Kharaj by Yahya bin Adam al-Quraisy (140-203 H /

757-818), a collection of hadith about Fiqha al-Annual.

(iv) Kitab al-Amwal by Abu Ubaid al-Qasim bin Salam (140-157 H /

774-838), works about policies and public finance.

(v) Kitab al-Annual by Abu Hamid bin Zanjawaih (180-251 H /

796-865).

The state where works of Islamic thinkers on economics were neither

given due notice nor developed continued from the middle Islamic
period to the time when the Islamic civilization ended and right
up to the era of the Uthmaniah rule which was centred in Turkey.
As a result, not much was written about Islamic economics and
eventually a vacuum was formed and the spread of the knowledge
became very much constrained. A contemporary Islamic scholar,
Kahf (1989) was of the view that too little effort has been made to
review the views and guidelines on economics produced by Islamic
thinkers of the past, like Abu Yusuf (d. 182 H), Yahya bin Adam
(d. 303 H), al-Ghazali (d. 505 A.H.), Ibn Kushad (d. 595 A.H.),
al-Izz bin Abdus-Salam (d. 66 H), al-Farabi (d. 339 H), lbn Taymiah
(d. 728 H) and Ibn Khaldun (d. 808 H). Views and ideas expressed
by this group of thinkers could stimulate other Muslim economists
to study the development and the paths of knowledge associated
with Islamic economy. This way, Muslim economists could reassess
18 ( IIAP I I K 1

the applicability of the Islamic economics that had been developed

and increase its scope for the benefit of the present-time man.
Khan (1989) was of the opinion that there currently exist three
groups of Muslim intellectuals who have contributed towards the
revival of discussions on this knowledge. The first is the group
of ulama (respected people with in-depth knowledge of Islam)
who reinitiated discussions on the concept of Islamic economics.
This group pioneered the move and is of the view that teachings
of Islam regarding economy and economics are all-encompassing
and could solve economic problems faced by man. This group
uses past methods whereby research is done based on authentic
sources. The second group is the modern group, who performs
reinterpretations based on authentic sources and undertakes to
modify views of traditional ulama in line with current situations.
The views of this modem group, however, sometimes fail to receive
public support. The third group who discusses Islamic economic
matters comprises economists educated in the West. They possess
expertise in the field of economics and they perform analysis guided
bv the views of the ulama. This third group has contributed a great
deal to the advancement of knowledge in Islamic economics.
To date, although there is already ample writings and research
on Islamic economics, there are still gaps to be filled and still many
economic issues which have yet to be resolved trom the Islamic
perspective.

ISLAMIC ECONOMIC METHODOLOGY

According to Kahf (1989), an economic system should be

founded on an ideology that provides the system with two main
components, the first being fundamentals and objectives, and the
other component consisting of principles and concepts associated
with it. In other words, to understand Islamic economic system, one
 FUNDAMENTAL** OF ISLAMIC ECONOMIC SYSTEM 19

must first understand Islamic economic methodology. Blaug (1980)

believed that methodology of a particular body of knowledge would
examine aspects related to concepts, theories and principles of that
body of knowledge. Due to the fact that Islamic economic system
is a branch of knowledge which has yet to be fully developed,
there are, hence, many differing views about Islamic economic
methodology. Even though there is an abundance of writings on
Islamic economic system, most of the writings only revolve around
concepts, leaving out theory. Khan (1989) felt that the writings are
conceptual in nature because they revolve around commentaries
and views guided by the teachings of Islam. These writings are not
theoretical in nature because they do not take into account actual
current situations of mankind. The fact that at present, writings that
can be regarded as essential readings on Islamic economic system
are still non-existent shows that there is yet a long way to go in
the advancement of knowledge in Islamic economics. According
to Siddiqi (1982), three areas of similarity that exist between the
various economic methodologies of the West are:

(i) The basic assumption that a person places importance on

himself and behaves in a rational manner.

(ii) His main goal is material gain.

(iii) Each person has the tendency to maximize his possessions of

material goods and also has the knowledge and capacity to
determine what is best for him.

The above are assumptions of the Western economic methodologies

about man. However, the authenticity of such views has to be
validated in developing an Islamic economy. The Quran has
outlined several natural attributes of man. The following are some
of them:

Allah doth wish to lighten your (difficulties): for man teas created
weak (in flesh). (Q4: 28)
20 cHAi-rtR 1

Fair in the eyes of men is the love of things they covet: women and
sons; heaped up hoards of gold and silver; horses branded (for blood
and excellence); and (wealth oft cattle and -well-tilled land. Such are
the possessions of this world's life; but in nearness to Allah is the best
of the goals (to return to). (Q3:14)

When trouble toucheth a man, he crieth unto Us (in all postures) -

lying down on his side or sitting, or standing. But when We have
solved his trouble, he passeth on his way as if he had never cried to
Us for a trouble that touched him! Thus do the deeds of transgressors
seem fair in their eyes!
(Q10: 12; see also Q39: 49; Q17:67; and Q17:83)

But verily thy lord is full of grace to mankind: yet most of them are
ungrateful. (Q27:73; see also Q7:10; Q23: 78; and Q39: 49)

We have explained in detail in tins Quran, for the benefit of mankind,

every kind of similitude: but man is, tn most things, contentious.
(Q18: 54; see also Q17: 89; Q14: 34; Q25: 50; Q30:8;
Q22: 66; and Q96:6-7)

Truly man -was created very impatient.

Fretful when evil touches him.
And niggardly when good reaches him.
(Q70:19-21; see also Q17:100, and Q100: 6-8)

Man does not weary ofasking for good (things), but if ill touches him.
he gives up all hope (and) is lost in despair. (Q41:49)

Man is a creature of haste: soon (enough) I will show you My Signs:

then ye will not ask Me to hasten them! (Q21:37)

We have not sent thee but as a universal (Messenger) to men, giving

them Glad Tidings, and warning them (against sin), but most men
understand not.
(Q34: 28; see also Q30:6; Q34: 36; Q39:49; and Q45: 26)
 FUNDAMENTALS OF ISLAMIC ECONOMIC SYSTEM 21

From the above verses, it can be seen that some of the attributes of
mankind include having a preference for material things, being
easily swayed or misled, being unappreciative, argumentative and
contentious, stinginess, hopelessness, need for haste and ignorance.
Although these may be the natural attributes of mankind, this
does not mean that Muslims should perpetuate these attributes.
Muslims have been given guidelines that must be adhered to.
These guidelines are in contrast to the above mentioned natural
attributes of mankind. This is one of the uniqueness of Islam.
Allah (s.w.t.) wishes to test how far a believer of Islam is willing to
comply with His rules. As an example, Islam forbids its believer to
be selfish. Islam not only encourages one to be generous, but also
must be willing to sacrifice for others. Many verses in the Quran
urge Muslims to do good unto one another and praise those who
are unselfish (see Q4: 36; Q5: 93; Q16: 90; Q16; 128; Q17: 23; Q28:
T7-, Q42: 40; and Q60: 8). Secondly, it is improper for Muslims to
set possession of property or wealth as their goal. This is because
each and everything on this earth belongs to Allah (s.w.t.). As an
example, in Surah al-Baqarah verse 107, Allah (s.w.t.) says:

KiKWest thou not that to Allah belongeth the dominion of the heavens
and the earth ? And besides Him ye have neither patron nor helper.
(Q2: 107; see also Q2: 284; Q3: 109 and 129; Q4: 126, 131 and 132;
Q5: 120; Q6: 12; Q9: 116; Q10: 66; Q16: 52 and 77; Q18: 26;
Q20: 6; Q21: 19; Q22: 64; Q24: 42 and 64; Q25: 2; Q30: 26;
Q31: 26; Q34: 1; Q39: 44; Q42: 4, 49 and 53; Q45: 27;
Q48: 4, 7 and 14; Q53: 31; and Q57: 2 and 5)

Besides this, the sirah (traditional biographies) of the Prophet

(p.b.u.h.) shows that He and his Companions practised a highly
moderate lifestyle. Moderation is an important concept in Islam. A
person who practises the concept of moderation in his life is able to
avoid becoming trapped in extremist groups, or developing greed
for wealth and riches, or becoming selfish and unwilling to be
charitable. Instead, he is involved in jihad (striving with ever}' might
22 charter 1

for the cause of Allah (s.w.t.)). The following verses and Hadith may
be used as a guide.

And be moderate in thy pace, and lower thy voice: for the harshest of
sounds without doubt is the braying of the ass. (Q31: 19)

O ye who believe! Make not unlawful the good things which Allah
hath made lawful for you. but commit no excess: for Allah loveth not
those given to excess.
(Q5: 87; see also Q2: 190; Q6: 141; Q7: 31 and 55;
Q17: 29 and 110; Q64: 16; and Q73: 20)

It is narrated on the authority of Abu Huraira that the Prophet

(p.b.u.h.) said: Faith has over seventy branches or over sixty branches,
the most excellent of which is the declaration that there is no god but
Allah, and the humblest of which is the removal of what is injurious
from the path: and modesty is a branch of faith.
(Sidiqi, undated, p. 27)

Although Muslims must practise moderation, this does not imply

that Islam prevents Muslims from pursuing wealth. In fact, the
possession of wealth would enable Muslims to perform commands
like jihad, the giving of zakat (alms) and helping others. Verses 20
and 21 of Surah at-Taubah state:

Those who believe, and suffer exile and strive with might and main, in
Allah's cause, with their goods and their persons, have the highest rank
in the sight of Allah: they are the people who will achieve isalvation).
Their Lord doth give them Clad Tidings of a Mercy from Himself of
His good pleasure, and of Cardensfor them, wherein arc delights that
endure.
(Q9: 20 and 21; see also Q2: 43, 110, 177, 195, 277 and 267;
Q4:95 and 162; Q5: 35 and 55; Q9:41 and 103; Q14: 31; Q22: 78;
Q29: 6 and 69; Q34: 39; Q45: 15; Q57; 10; and Q92: 17-18)

Apart from the verses above, there are many more that explain the
benefits attained by those who do good unto others (see also Q2:25,
 FUNDAMENTALS OF ISLAMIC ECONOMIC SYSTEM 23

245, 261 and 265; Q3: 198; Q4:57,85,122,124 and 173; Q5:9; Q6: 160;
Q10: 26; Qll: 23; Q14: 23; Q15: 45-48; Q16: 30 and 97; Q18: 30-31;
Q22: 23 and 50; Q27: 89; Q29:7 and 58; Q30: 15; Q31: 8; Q32:19; Q35:
33; Q39:10 and 20; Q43: 71; Q55:48-76; Q56: 11-40; Q57: 11 and 18;
Q64: 17; Q73: 20; Q76: 5-6 and 12-22; Q78:31-36; and Q85: 11).

Thirdly, in reality mankind does not know what is best for it

(see Q4: 11). Hence, human beings require guidance in living their
lives. In Islam,'only Allah (s.w.t.) is All-Knowing. Due to the highly
limited knowledge that mankind has gathered, it is pertinent that
humans look towards the Quran and Hadith to guide them in
carrying out their responsibilities on this earth. Since there exists
a marked difference between the Western perspective of economy
and that of Islam, a different platform for economy in Islam is
present. According to Khan (1989), Islamic economic methodology'
must consider the following points:
(i) The main function of methodology is to help attain truth.
Hence, the pillars of Islamic economy consist of the teachings
of the Quran and Hadith, whereby the source is pure and the
truth of it is unquestionable. Methodology and views from
man only exist when no clear direction can be obtained from
the two sources.
(ii) The field of Islamic economics incorporates Islamic values,
analysis of the actual state of the economy and transformation
of the methods and ways of the existing economy to an Islamic
economy model. The pillars of Islamic economy only provide
guidance on a number of small issues. For a major part of the
actual state of the economy, therefore, what are needed are
views and thoughts of man within the framework of Islamic
teachings. The issue of methodology, hence, becomes even
more crucial when human thoughts and views are adopted.

(iii) Developing an economic model involves concepts called

inductive reasoning and deductive reasoning. What this
means is that man will use his mental faculties and logic to
24 CHAPTER 1

arrive at particular decisions or views. Inductive reasoning

is not forbidden in Islam. In fact, the Quran urges man to
observe the natural world and all aspects of its creation.
Deductive reasoning is used by Western economists with
the assumption that man has perfect knowledge to predict
the future. The development of Islamic economics, however,
adopts this concept with its own modification. This follows
from the fact that in Islam, even though man has knowledge
and skills, he is not capable of making accurate predictions.
As such, every model that is to be built must take into account
various differing factors and aspects.

(iv) Various assumptions are made when discussing aspects of

economics from the perspective of the West. For example,
man is said to be a rational being who has self-interest and
who wants to maximize his gains, etc. However, in discussing
Islamic economics, assumptions made must rightly be based
on the Quran and Hadith.

(v) Islamic economics had been deliberated upon from era to era
by many Islamic experts and thinkers. These thinkers were
concerned about the economic issues during their time and
attempts were made to offer views and methods of solution.
The majority of these Islamic thinkers used multidisciplinary
methods of the normative kind, and this tradition should be
continued in the ad vancement of present-day economics. In line
with this, various fields of knowledge have to be consolidated
and taken into account in the process of developing the
knowledge of Islamic economics.

Based on the above elaboration, it may be concluded that several

main characteristics are seen in an Islamic economic system. They
are as follows:

(i) Islamic economics uses a framework from two principal

sources, the Quran and Hadith, and these sources are not to
 FUNDAMENTALS OF ISLAMIC ECONOMIC SYSTEM 25

be questioned nor their truth doubted. This differs from the

basic concept of Western economics which is questionable and
changes with time.

(ii) The development of Islamic economics must use the inductive

method. This method offers explanation of the correctness
or otherwise of assumptions and predictions based on
reasonability and empirical evidence.

(iii) Islamic economics is founded on ethical values such as justice,

fairness, moderation, cooperation, helpfulness and altruism.
These values must exist in the behaviour of all units in Islamic
economy.

(iv) Islamic economics is by nature normative, which means it has

comprehensive rules that are used by all.

(v) Islamic economics takes into consideration issues which differ

from regular economics. It places importance on the falah
(ultimate success) of man which will eventually lead to the
establishment of the falah of society.

In Islam, the development of each body of knowledge should be

with a particular purpose. The aim of Islamic economic knowledge
is one that would be achieved by taking into consideration in totality
all aspects of the Islamic religion.

THE ESSENCE OF ISLAMIC ECONOMICS

Based on the various definitions made by Western intellectuals,

the crux of economic issue lies in the existence of limited resources
to meet unlimited needs of man. Hence, the important points to
consider in discussing basic economic concepts are: what is to be
produced, how it will be produced and for whom it is produced.
2b CHATTER 1

Therefore, one must deliberate whether the development of

knowledge in Islamic economics should go the same path as the
epistemology of conventional economics.
The first point which needs to be corrected is the limitedness
or scarcity of all resources on the face of the earth as perceived in
conventional economics. As such, a Western system which takes
into account the methods of distributing these limited resources was
established. These limited resources are also known as economic
goods. Hence, this discipline of foe economics shall not exist if
everything that man wants can be made available to him without
depleting the resources. If we also accept as a fact that resources
created by Allah (s.w.t.) are limited, the basis of foe deliberations
of Islamic economics would also be on the same platform of
assumptions as the Western economics.
However, some Islamic economists are of the view that limited
resources are not present from Islamic point of view. According to
Ariff (1989), Allah (s.w.t.) has made available sufficient resources to
mankind to last till the end of life. Scarcity of resources is not due
to their non-existence or depletion or extinction, but instead it is
due to weakness on the part of man in exploring and acquiring the
resources or other similar resources as substitutes. As an example,
Allah (s.w.t.) constantly encourages Muslims to seek His bounty on
the face of foe earth. This is evident in the following verses:

Your Lor<l is He that maketh the ship go smoothly for you through the
wo, inorder that ye may seek of His Bounty. For He is unto you Most
Merciful. (QI 7:66)

But seek, with the (wealth) which Allah has bestowed on thee, the
Home of the Hereafter, nor forget thy portion in litis world: but do
thou good, as Allah has been good to thee, and seek not (occasions for)
mischief in the land: for Allah loves not those who do mischief.
(Q28: 77; see also Q30: 41)
 FUNDAMENTALS OF ISI AMIC ECONOMIC SYSTEM 27

And when the prayer is finished, then may ye disperse through the
land, and seek of the Bounty of Allah: and celebrate the Praises of
Allah often (and without stint): that ye may prosper. (Q62:10)

If is He who has made the earth manageable for you, so traverse ye

through its tracts and enjoy of the Sustenance which Hefurnishes: but
unto Him is the Resurrection. (Q67:15)

It is clear from the above verses that nowhere in the Quran can one
find anything that informs Muslims about depletion or extinction
of the bounties of Allah (s.w.t,). Nevertheless, the verses do provide
instructions and rulings which Muslims have to comply with. Some
of the rulings and guidances are:

(i) Wealth or the bounties of Allah (s.w.t.) are not confined to

certain areas. In other words, Muslims are encourage to
disperse through land and sea to seek the bounties of Allah
(s.w.t.). Allah’s (s.w.t.) bounties are found in abundance in all
places and ought to be sought and discovered.

(ii) In seeking wealth, it must never be forgotten that there is life

in the Hereafter. Hence, every effort made by man in seeking
the bounties must be made with full consideration of the fact
that he is held responsible for all his actions in the Hereafter.

(iii) In exploring to seek the bounties, no destruction must be done

to the environment. The meaning here is broad. Generally,
man can seek as much of the bounties on earth as he wants,
but at the same time he must not damage the environment
to the extent of endangering life on earth and depleting
non-renewable resources.

The second most important factor that is recognized by the West

in developing its knowledge in economics is that man’s desires are
unlimited. With the insatiability of desires, economy will continue
to advance and products will continue to be created in order to
28 < MAPI I K 1

meet the unlimited demands. There are many theories put forward
by the West in discussing man's desires.
One of the early theories of the West that has been accepted by
many is the Hierarchy of Needs put forward by Abraham Maslow'.
According to this theory, man has five levels of needs, and each
person will work towards meeting his needs at the basic level before
working on to meet his needs at the next level, and so on until he
reaches the highest level (Maslow, 1943). The first level is the level
of basic or psychological needs, where man needs food, lodging
and freedom from diseases. The second level consists of need for
security, freedom from threats and danger. The third level involves
social needs, that is needs of love, affection and belongingness.
The fourth level is the level of self-esteem, where one wishes to
be accepted and valued by others. The final, fifth level involves
aesthetic needs. Here, one will work towards fulfilling personal
desires based on the ability and capacity that one possesses. Apart
from Maslow, many other Western theorists have also presented
their views on man's needs and desires.
Zarqa (1989) in his writings on human behaviour from the
Islamic perspective, took into consideration the views of al-Gazali
and al-Shatibi that the desires of Muslims may be categorized
into three main hierarchies, namely necessities, conveniences and
refinements. As an example, the term 'needs' involves activities
of forming, developing and maintaining the five main aspects
necessary to become the best unintalt, namely religion, living,
thought, children and wealth. There exists an abundance of
teachings based on the Quran and Sunnah which educate man
towards that perfection. The same goes for other activities to fulfil
the other needs which must be done under the guidance of Islamic
teachings.
The third important factor that must be considered when
developing Islamic economic knowledge is the reassessment of
economic theories developed by the West. This is necessary because
the theories may not be suitable and cannot be used as a basis for
 FUNIEAMENTALS Of ISLAMIC ECONOMIC SYSTEM 29

developing Islamic economics. A rift (1989) presented a number of

Western economic theories which are questionable or which cannot
at all be used in Islamic economics. Examples of theories that need
to be re-examined are: the theory involving competition, the theory
of maximizing gain and the theory associated with interest rates.
Based on the crucial facts discussed above, it can be concluded
that the essence of Islamic economics differs very much from that of
Western economics. Further, the development of the knowledge in
question is closely related to development of die individual and the
Islamic society, and this development is in accordance with rulings
laid down by the Quran and Sunnah. Karim (2002) summed up
that the process of the development of Islamic economics must be
founded on the five principal bases of lauhid (oneness of Allah), adl
(justice of Allah), nubuwwah (prophethood), khalifalt (representative
of Allah on earth) and ma'ad (ultimate destiny of humankind).
Tauhid is the framework that positions man’s behaviour in
line with the purpose of his creation. Because mankind is created
to worship Allah (s.w.t.), it follows that humans should behave
responsibly in this world. Consequently, all actions in connection
with economic development or business should be accompanied by
responsibility. Anyone whose action goes against Islamic teachings
shall be held responsible for his action. The concept of adl or fairness
includes the philosophy of not doing wrong unto others and not
being wronged. Hence, exploitation and unfaithfulness will not
exist. Nubuu’wah is the concept whereby mankind must be guided
by the behaviour and actions of the prophets. Among the qualities
associated with this are siddiq (truthfulness), amanali (responsibility
and trustworthiness)./af/iHriii/i (smartness, intelligence and wisdom)
and tabligh (receptiveness to views of others and the ability to
communicate well). The concept of khalifah involves man as a
leader and caretaker of all things on earth. Through this concept,
man carries the responsibility to use resources in ways that benefit
not only human beings but also all other creations on earth. The
last concept, ma'ad is the concept of the existence of the Day of
30 CHATTEK 1

Judgement. In line with this concept, man is to do good in order to

obtain rewards on the Day of Judgement.
Chapra (1971) presented the following as the values and goals
of Islamic economics:

(i) Economic well-being within the framework of Islamic moral

values.

(ii) Universal brotherhood and justice.

(iii) Fair and just distribution of income or wealth.

(iv) Freedom of the individual in the context of social welfare.

One of the beauty and strength of Islam lies in its teaching on

the importance of reaping benefits both for this world and for
the Hereafter. Islam encourages Muslims to raise their standard
of living by seeking as much of the bounties of Allah (s.w.t.) in
this world as possible. This confirms that Islam does not forbid
the accumulation of wealth, as is evident from the verses Q17: 66;
Q28: 77; Q62: 10; and Q67: 15, where Muslims are urged to seek
Allah's (s.w.t.) bounties on this earth. Apart from this, the Quran
also states that everything that exists on the face of the earth has
been created for Muslims. Examples of such verses are:

It is He who hath created for you nil things that are on earth; moreover
His design comprehended the heavens,for He gave order and perfection
to the seven firmaments: and of all things He hath perfect knowledge.
(Q2: 29)

Say: Who hath forbidden the beautiful (gifts) of Allah, which He hath
produced for his Servants, and the things, clean and pure, (which He
hath provided) for sustenance? Say: They are, in the life of this world,
for those who believe, land) purely for them on the Day of Judgement
Thus do We explain the Signs in detail for those who understand.
(Q7:32)
 FUNDAMENTALS Of ISLAMIC ECONOMIC SYSTEM 31

A lot of good can come about if Muslims are able to gather Allah's
(s.w.t) bounties by upgrading their economic level. For instance,
through his wealth a Muslim could contribute zakat, give out alms,
provide aid to others and participate in striving in His cause as
urged in Islam. The following verses have reference to this fact:

And be steadfast in prayer; practise regular charity: and bow down

your heads with those who bow down tin worship).
(Q2:4.3; see also Q2: HO, 117 and 277; Q4: 162;
Q5: 55; Q9: 103; and Q92: 178)

O ye who believe! Do your duty Io Allah, seek the means of approach

unto Him, and strive with might and main in His cause; that ye may
prosper.
(Q5: 35; see also Q4:95; Q9: 20-21; Q9: 41; Q22: 78;
Q29: 6; Q45:15; and Q29: 69)

And spend ofyour substance in the cause of Allah, and make not your
own hands contribute to (your) destruction; but do good; for Allah
loveth those who do good.
(Q2: 195; see also Q2: 267; Q14: 31; Q34: 39; and
Q57:10)

Besides verses of the Quran quoted above which call for Muslims to
seek Allah's (s.w.t.) bounties and to use them in the best way possible
to attain returns in this world and the Hereafter, there are a number of
Hadith which deliver the same message. As an example, the Prophet
(p.b.u.h.) recommends that Muslims spend part of their time to
perform worldly commitments and part of it to pursue matters of
tlie Hereafter, and urges Muslims to do good and to use their wealth
in ways that achieve Allah's (s.w.t.) blessings. The same goes for the
issue on profit or gain. In Western economics, the theory related to
profit is the theory of profit maximization. In Islamic economics, the
matter of profit is not only seen from the perspective of economic
enhancement or as monetary gain, but also as an enhancement of
32 CHATTER 1

faith. In Islam, profit is seen from a long-term perspective as well

as gains in this world and in the Hereafter. The definition of people
who attain prosperity and the qualities they possess are stated in
the Quran (see Q2: 2-5; Q3: 200; Q5: 35. 90 and 100; Q6: 21 and 135;
Q7: 8-9; Q8: 45; Q9: 88; Q35: 29; Q41: 35; Q42: 20; Q45: 30; and Q64:
16). In Islam, the people who prosper are those who are faithful and
devoted to Allah (s.w.t.) and tire Quran has laid down the qualities
that are required for people to achieve prosperity.
Secondly, the goal of Islamic economic development is
characterized by the concepts of universal brotherhood and
socio-economic justice. This means Islamic economic development
will not benefit only one group of Muslims while other groups of
Muslims are left behind in hardship and suffering. This concept of
universal brotherhood is very much emphasized in Islam. In fact,
Allah (s.w.t.) created male and female in mankind and in various
ethnicity and groups in order for them all to know one another (see
Q49: 13). Emphasis on the importance of universal brotherhood
can be found in various verses of the Quran and Hadith which urge
Muslims to do good among themselves. The following may be used
as a guide:

Narrate/ by Abdullah bin Umar: The Prophet (p.b.u.h.) said, "A

Muslim is a brother of another Muslim, so he should not oppress
him. nor should he hand him over to an oppressor. Whoever fulfilled
the needs of his brother, Allah will fulfil his needs; whoever brought
his (Muslim) brother out of a discomfort, Allah will bring him out of
the discomforts of the Day of Resurrection, and whoever screened a
Muslim, Allah will screen him on the Day of Resurrection."
(Khan, 1986, p. 373)

Narrated by Anas: The Prophet (p.b.u.h.) said, "Help your brother,

whether he is an oppressor or he is an oppressed one. “ People asked.
"O Allah 's Apostle! It is all right to help him if he is oppressed, but
how should we help him if he is an oppressor?" The Prophet said. "By
preventing him front oppressing others." (Khan, 1986, p. 373)
 ILNDAMLNTAIS OF ISLAMIC ECONOMIC SYSTEM 33

Abu Musa reported the Prophet (p.b.u.h.) as saying: "A believer is like
a brick for another believer, the one supporting the other."
(Sidiqi, undated, p. 1368)
Nu'man bin Bashir reported the'Prophel (p.b.u.h.) as saying: "The
similitude of believers is that of one body; when the head aches, the
whole body aches, because of sleeplessness and fever."
(Sidiqi, undated, p. 1368)

The above Hadith is clear proof of the concept of universal

brotherhood in Islam. Hence, one important guideline in the
development of Islamic economy is the concept of the mutual
sacrifice and cooperation within the framework of Islamic
brotherhood. This concept of universal brotherhood is closely
related to the concept of justice, another concept of prime importance
in Islam. There are many verses in the Quran that state this fact.
Among them is the following:

O ye who believe! Stand out firmly for Allah, as witnesses to fair

dealing, and not let the hatred of others to you make you swerve to
wrong and depart from justice. Be just: that is next to piety: and fear
Allah. For Allah is well-acquainted with all that ye do.
(Q5: 8; see also Q4: 58; Q6: 152; and Q49: 9)

According to Chapra (1994), this concept of justice may be split

in two parts, social justice and economic justice. Social justice is
closely related to relationships among Muslims regardless of race,
colour or creed. This is so because in Islam the only factors that
differentiate between individuals are one's faith and piety. In line
with this, Muslims are prompted to perform good deeds and be of
help to one another, for this would strengthen Islamic brotherhood.
This call towards doing good deeds is emphasized in many verses
in the Quran, and it covers doing good deeds through words and
action (see Q2: 95 and 104; Q4: 36 and 48; and 148-9, Q5: 93; Q16:
90 and 128; Q17: 23 and 153; Q28: T7; Q29: 46; Q42: 40; and Q60: 8).
Economic justice means the absence of elements of exploitation
34 CHATTER 1

and misuse of other people's rights for one's own interest. In other
words, tlie concepts of morals and ethics need to be complied with
at all times. As an example, verse 183 from Surah asy-Syura states:

And withhold not things justly due to men, nor do evil in the hind,
working mischief. (Q26:183)

The above verse indicates that Islam forbids one from taking away
the rights of others at one's will for one's self-interest. Hence, in
Islamic economics, it is necessary for a producer to know' not only
his own rights, but also the rights of the workers who are working
together to produce goods for him. as well as the rights of those
who purchase the products.
The third goal set out by Chapra in the concept of Islamic
economics is the fair and equitable distribution of income. This
goal is clearly related to the concept of justice in Islam. The basic
concept of Islamic economics is the assurance that every Muslim
would be able to enjoy Allah's (s.w.t.) bounties on this earth. This is
especially so when it is mentioned in the Quran that all resources
on earth have been created for man and that man is the master of
the resources (see Q2: 30; Q6: 165; and Q35:39). In connection with
this, programmes of wealth or resource distribution to the less
fortunate are definitely not overlooked in the development of the
Islamic economy.
Distribution of wealth to the less fortunate is divided into
three categories. First, Islamic economic development takes into
consideration giving aid to those without any occupation and
ensures that this group receives payment at an appropriate rate.
Secondly, emphasis is given to the collection and payment of zakat
(compulsory charity), whose distribution will not only help the
less fortunate but also aid in the betterment of Muslims. Thirdly,
distribution of wealth of a deceased must be done urgently, without
having to freeze the assets. The concept of fair and equitable
distribution of income does not mean that each Muslim gets an
even portion regardless of the contribution made by the individual.
 FUNDAMENTALS OF ISLAMIC ECONOMIC STS! F.M 35

Islam does not forbid the accumulation of wealth, or the attainment

of more gains or a higher placement in society by an individual.
The verses below clearly show the existence in Islam of inequalities
in terms of position, ownership of wealth and status of living:

It is He Who hath made you (His) agents, inheritors of the earth: He

hath raised you in ranks. some above others: that He may try you in
the gifts He hath given you: for thy Lord is quick in punishment: yet
He is indeed Oft-Forgiving. Most Mercifid. (Q6:165)

Verify thy Lord doth provide sustenance in abundance for whom He

pleaseth, and He provideth in a just measure. For He doth know and
regard all His servants.
(QI 7: 30; see also Q17: 21; Q2: 269; Q13: 26; Q16: 15;
Q9: 21 and 62; Q30: 37; Q34: 36 and 39; Q39: 52; and Q42: 12)

The ultimate goal of Islamic economic system according to Chapra

is the freedom of the individual in the context of social welfare.
Freedom is the absolute right of an individual because in Islam,
mankind is created solely to worship Allah (s.w.t.). However, even
though man has been granted freedom, there are limitations that
must be observed. These restrictions are imposed should tile action
of a person contradict the limitations of the Syariah law or has the
potential to cause harm to himself or others. Islamic jurists are of
the view that individual freedom in the context of Islam is subject
to the following principles:

(i) The interest of the majority takes precedence over the interest
of the individual.

(ii) Although both lightening burdens and seeking benefits are

the main goals of Syariah, the concept of lightening burdens is
given priority.

(iii) A small loss is tolerated to avoid bigger losses, or a small profit

may be sacrificed to obtain bigger profits.
36 CHAPTER 1

FUNDAMENTALS OF ISLAMIC
ECONOMIC LAW

A system cannot be established without laws, rulings and

regulations that regulate the operation of the system. In Islam, the
regulations that control the lifestyle of Muslims are the Syariah
laws (a detailed description of this is done in Chapter 5). Islamic
economic system, therefore, is bound by the laws and regulations
as stipulated by Syariah.
Syariah laws are derived from four sources. The first source
is the holy book of the Muslims, the Quran. The Quran is the
authentic and eternal source of the Syariah laws. It contains the
words or messages of Allah (s.w.t.) that were passed through lite
Prophet (p.b.u.h.) to guide all mankind. These words and messages
are fundamental, all-encompassing and eternal.
The second source of the Syariah laws is the Hadith, which is
second in importance after the Quran. The Hadith comprises extracts
of information, accounts, history, anecdotes and records of the
Sunnah of the Prophet (p.b.u.h.) that have been passed down from
generation to generation and adopted by Muslims in maintaining
their faith and guiding their actions. The Sunnah (sunan in plural
form) describes the Prophet's (p.b.u.h.) habits, customs and the
things he used. It also relates to his behaviour, actions, made of
actions and verbal responses or comments in different life situations
and conditions.
The third source is called ijma. lima means collective views of
mujtahid or the collective agreement of Islamic jurists at particular
instances on issues ol law. A mn/tahid is an expert on Islamic law
and in other branches of the religion. Any person who undertakes
ijtihad, or who perseveres and thoroughly racks his brain in striving
to solve a problem, in particular a religious issue, is also known as
a mujtahid.
 FUNDAMENTALS Of ISLAMIC ECONOMIC SYSTEM 37

The fourth and final source is called qiyas. The original meaning
of this word is "to measure" or "to draw similarities between two
things" (Ali, 1950). In Syariah terms, qiyas is the process of reasoning
by analogy of the mujtahid with regards to difficult and doubtful
questions of doctrine or practice. The process involves comparing
the problem with similar issues or cases which have already been
solved using the rulings in the Quran and Hadith,
Both the Quran and Hadith are also known as al-adillat-al-
qatiyyah or absolute opinions or views, and it is evidence whose
truth cannot be disputed. This is so because these two sources
contain absolute truth and undoubted fundamental doctrines of
Islam. These sources are also sometimes known as the origin or
root of Syariah. ljma and qiyas, on the other hand, are known as
al-adillat-al-ijtihadiyyah or opinions or views obtained by exertion.
These two sources are also commonly called furu' or branches of
Syariah law. The use of these four sources in Syariah law bestows a
high standing on the Syariah laws in facing the complicated world
of today and in solving various problems related to modem living.

SUMMARY

Economics is a branch of knowledge that deals with the distribution

of resources on the face of the earth to meet man's needs. The
existing resources are said to be scarce, while the demands of man
are limitless. Hence, the use of these resources must be optimized so
that wastage can be prevented and man's needs can be met as best as
possible. This conventional economic knowledge can be categorized
into two categories, macroeconomics and microeconomics.
Macroeconomics covers factors of production, overall income,
price levels, funds, unemployment and the labour force as a whole.
Apart from that, also included in macroeconomics are causes
38 CHAT! ER I

of economic crises, determination of methods of investment and

consumption, management of a nation's finance and interest rates.
Microeconomics discusses the individual behaviour of man and
firms in order to determine the supply and demand of commodities
in the market.
Based on the macroeconomic and microeconomic concepts,
thinkers of the West established and implemented systems with
the ability to satisfy the needs of every unit in the society including
individuals, businesses and governments. Eventually, systems
with different characteristics, known as the capitalist and socialist
systems emerged. The capitalist system emphasized the individual
ownership of all factors of production, with the majority of decisions
determined by market mechanisms. The socialist system, on the
other hand, focused on public ownership with decisions made at
the central level.
Although the capitalist and socialist systems succeeded in
developing several races and societies in the world, flaws and
weaknesses appeared in the practice of the systems. At the end of
the 1980s and 1990s, a number of socialist nations fell. At the same
time the capitalist societies were in disarray. Such situation showed
that the systems were incapable of solving universal economic-
issues. In connection with this, Islam as a complete religion certainly
has its own unique economic system. The Islamic economic system
has fundamentals, essence and qualities which are distinct from
systems established by Western economists Further, the goals of
Islamic economic system encompass aspects such as economic
development within the framework of Islamic values and morals,
universal brotherhood and justice, equitable distribution of wealth
and individual freedom subject to social welfare.
In contrast to the conventional economic system where
regulations which are to be abided by are subject to man-made
rules, Islamic economic system complies with two groups of laws.
Tlie first is the Si/itriali legislation, comprising rules derived from
four sources, the Quran, Hadith, i/ma and qiyas. In principal, Islamic
 FUNDAMENTALS OF ISLAMIC ECONOMIC SYSTEM 39

economic system is a system of economy whose development

and implementation are governed by Syariah. Within this Islamic
economic system, knowledge related to Islamic banking has also
been developed. ,

REFERENCES AND FURTHER READING

Ali, Maulana M. The Religion of Islam. Lahore (Pakistan):

The Ahmadiyyah Anjuman Ishaat Islam, 1950.

Ariff, .Mohamed. "Economics and Ethics in Islam." In Readings in

the Concept and Methodology of Islamic Economics, edited by Aidit
Ghazali and Sved Omar, 96-119. Kuala Lumpur (Malaysia):
Pelanduk Publications, 1989.

Bahr, Laurens, Bernard Johnston and Louise A. Bloomfield, Collier's

Encyclopedia. New York (USA): Collier, 1969.

Barnhart, Robert K. The Barnhart Dictionary of Etymology. New York

(USA): The H.W. Wilson Company, 1988.

Blaug, Mark. The Methodology of Economics. Cambridge (USA):

Cambridge University Press, 1980.

Bronstein, Morris. Comparative Economic Systems, Models and Cases.

7thed. Illinois (USA): Irwin, 1994.

Chapra, M. Umar. The Economic System of Islam. Karachi (Pakistan):

Bureau of Composition, Compilation & Translation, University
of Karachi, 1971.

Chapra, M. Umar. Islam and the Economic Challenge. UK: Leicester

Islamic Foundation, 1994.

Fly, Richard T. French and German Socialists in Modern Times.

New York (USA): Harper, 1983.
40 CHATTER 1

Gregory, Paul R. and Robert C. Stuart. Comparative Economic System.

6th ed. Boston (USA): Houghton Mifflin Company. 1999.

GrolierAcademicEncyclopedia. New York (USA): Grolier International,

1987.

Kahf, Monzer. "Islamic Economics and Its Methodology." In

Readings in the Concept and Methodology of Islamic Economics,
edited by Aidit Ghazali and Syed Omar, 40-48. Kuala Lumpur
(Malaysia): Pelanduk Publications, 1989.

Kahf, Monzer. "Islamic Economics System: A Review." In Readings

in the Concept and Methodology of Islamic Economics, edited by
Aidit Ghazali and Syed Omar, 69-89. Kuala Lumpur (Malaysia):
Pelanduk Publications, 1989.

Kamus Ekonomi. Kuala Lumpur (Malaysia): Percetakan Dewan

Bahasa dan Pustaka, 1993.

Karim, Adiwarman. Ekonomi Mikro Islam. Jakarta (Indonesia): The

International Institute of Islamic Thought, 2002.

Khan, Muhammad Akram. "Islamic Economics: The State of

the Art." In Readings in the Concept and Methodology of Islamic
Economics, edited by Aidit Ghazali and Syed Omar, 49-68. Kuala
Lumpur (Malaysia): Pelanduk Publications, 1989.

Khan, Muhammad Muhsin, trans. The Translation of the Meanings

of Sahih al-Bukhari Vol. 3. Lahore (Pakistan): Kazi Publications,
1986.

Loucks. William N. and William G. Whitney. Comparative Economics

Systems. 9th ed. New York (USA): Harper & Row, 1973.

Low, Linda and Toh Mun Heng. Principles of Economics. Revised ed.
Singapore: Addison Wesley Publishing Company, 1997.

Maslow, Abraham H. "A Theory of Human Motivation." Psychological

Review, July 1943.
 HINOAMINIAtS Of ISLAMIC ECONOMIC SVSILM 41

Maslow, Abraham H. Motivation and Personality. New York (USA):

Harper, 1954.

Niemi, Albert W. Jr. Understanding Economics. Chicago (USA):

Rand McNally College Publishing Company, 1978.

Nomani, Farhad and Ali Rahnema. Islamic Economic Systems.

London, UK and New Jersey (USA): Zed Book Ltd., 1994.

Samuelson, Paul A. and William D. Nordhaus. Economics.

New York (USA): McGraw-Hill, Inc., 1995.

Schnitzer, Martin C. Comparative Economic Systems. Ohio (USA):

South-Western Publishing Co., 1994.

Siddiqi, Hamid, trans. Sahih Muslim Vols 1 and 4. Beirut (Lebanon):

Dar al Arabia Publishing, Printing & Distribution, undated.

Siddiqi, M. Nejatullah. "An Islamic Approach to Economics."

Working paper presented at the Seminar on Islamization of
Knowledge, Islamabad (Pakistan), January 1982.

Siddiqi, M. Nejatullah. Teaching Economics in Islamic Perspective.

Saudi Arabia: Scientific Publishing Centre, King Abdulaziz
University, 1996.

Smith, Adam. The Wealth of Nations, edited by Edwin Cannan.

New York (USA): Modem Library, 1937.

Zarqa, Anas. "Islamic Economics: An Approach to Human Welfare."

In Readings in the Concept and Methodology of Islamic Economics,
edited by Aidit Ghazali and Syed Omar, 21-39. Kuala Lumpur
(Malaysia): Pelanduk Publications, 1989.
 CHAPTER

HISTORY AND DEVELOPMENT

OF THE ISLAMIC BANKING
SYSTEM

This chapter discusses the establishment and development of the Islamic

banking system which can be traced back to the birth of Islam in Mecca.
The Islamic banking conceptfailed to expand to become a complete banking
system in the early years of Islam. Its development only picked up again in
the 1960s. before becoming rapid in the 1970s. The development of Islamic
banks in certain countries is also discussedfor comparison purposes. This
is because not all Islamic banks receive full support from their respective
governments. Some have toface numerous obstacles. There are some which
initially received special privileges, but later had the privileges taken away
from them. There are also others which are given special status and are
exempted from a number of regulations and lines.

43
44 CHATTER 2

INTRODUCTION

The Islamic banking system (IBS) is defined as a banking system

whose principles underlying its operations and activities are
founded on Islamic or Syariah rules. This means that all operations
of the Islamic bank, that is, transactions involving either deposits
or financing, must be based on Syariah principles. Such principles
also cover other banking transactions like money order transaction,
letter of guarantee, letter of credit and foreign exchange. The main
factor that distinguishes Islamic banks from conventional banks is
that all transactions are administered without involving elements of
interest or riba. This is due to the fact that Islam forbids the giving
or receiving of riba. A financial institution cannot be regarded as an
Islamic banking institution if its operations involve elements of riba.
Besides this, the principal objective of the establishment of Islamic
banks is to cater to the needs of Muslims in banking transactions.
The business management of the banks is based on the concepts of
justice and fairness in the interests of society as a whole. The banks
are also founded on rulings set in the Quran and Hadith.
The establishment of Islamic financial institutions whose
operations are based on true Syariah principles is a fairly recent
phenomena compared to conventional banking. Modem
conventional banking system came into existence nearly 420 years
ago with the establishment of Banco Della Pizza at Rialto in
Venice in 1587 (Homoud, 1485). Nevertheless, in England, modem
conventional banks were regarded as non-existent before 1640;
the Bank of England was only established in 1694 (Sumner, 1971).
The establishment of Mit Ghamr Savings Bank in Egypt in 1963
which operated based on Syariah principles marked the early
history of Islamic banking and became an eye opener for Islamic
thinkers and economists around the world. The success of the
Islamic bank in catering to deposit and credit needs of clients
proved that Syariah principles were still applicable and could be
adopted by modern-day businesses. From that time onwards.
 HISTORY ANO DEVELOPMENT Of THE ISLAMIC BANKING S>SI I M 45

many Islamic banks were established worldwide, particularly in

Islamic countries. According to figures released by the International
.Monetary Fund, there were more than 300 financial institutions
with operations based on Syariah rules in 75 countries as at end of
2007. The increase in asset value of Islamic banks exceeded 15% per
annum, and it was estimated that the asset value of Islamic financial
institutions worldwide at the end of 2007 was US$250 billion
(www.imf.org). Activities carried out included all transactions
of conventional banks, activities of merchant banks, investment
activities, insurance services, mortgage, hire purchase, advisory
services and other banking transactions. The establishment of
Islamic banks has not been limited to Muslim countries. Islamic
banking has gained a footing in non-Muslim countries as well.
For example, the Islamic Banking System International Moldings
established in Luxembourg in 1978 was the first Islamic financial
institution set up in a non-Muslim country. This was followed by the
establishment of Dar al-Mal al-Islami in Switzerland in 1981. Apart
from this, some banks operating in London and other financial
centres in Europe have started using Islamic banking techniques
and instruments to cater to the needs of their Muslim clients as well
as the needs of Islamic banks which have business relationships
with them. Most of the joint-venture banks between European and
Arabic parties offer international trade transactions based on the
principle of murabahah.
Banking products based on Syariah principles are also offered
by foreign conventional banks. Most of the products or services
offered are in the form of investment certificates based on Syariali
principles. As an example, Kleinworth Benson offered Islamic Unit
Trust in 1986. The Union Bank of Switzerland also offered Islamic
Investment Fund (Wilson, 1990). The existence of Islamic banks in
Western countries is nothing out of the ordinary. In fact, various
financial institutions that offer Islamic banking products have been
set up in many Western countries such as the United States, the
United Kingdom and Australia.
46 CHATTER 2

In (lie United States, Islamic banking was introduced not only in

financial institutions but in educational institutions as well. There
are more than 20 Islamic financial institutions in the United States
which offer deposit facilities, financing and fund management.
Meanwhile, there are several educational institutions that are
offering courses and seminars on Islamic finance. For instance,
Harvard University holds annual forums on Islamic finance. The
American Finance House - LARIBA, which was established in
1987, has become the most advanced Islamic financial institution
and currently operates in 35 states in the United States. It offers
housing financing services, small businesses financing and trade
financing (www.lariba.com). In the United Kingdom, the first
Islamic bank there, Islamic Bank of Britain I’lc began operations
on 6 August 2004. It is envisaged that the 1.8 million .Muslims in
the United Kingdom will have the opportunity to do their banking
businesses with the bank (www.banking-business-review.com).
Meanwhile, the Muslim Community Co-operative Australia
(MCCA) established in 1989, was the first Islamic financial institution
in Australia. Withan initial capital of A$22,300 and only ten members,
its total assets have grown to AS26 million with a membership of
5,619, which represents an increase of about 50 members on average
every month (www.mcca.com.au). This institution offers savings and
financing facilities using the principles of muraba/uih, inudharaba/t,
iniisyarakalt and qardluisstin. Besides these facilities, MCCA also offers
facilities for the collection and distribution of zakat.
The fall of the Soviet Union also opened up opportunities for
Islamic banks to operate in regions which were once under Soviet
rule. Fhe Albaraka Group began its operations by setting up a
bank in Kazakhstan, named Albaraka Kazakhstan Bank as well
as establishing joint ventures in Uzbekistan. Moreover, Islamic
banking had gained its footing in Albania (Rudnick. 1992). Besides
these regions, financial institutions based on Syariah are also found
in Russia (BAUR Bank) and in China (Ningxia Islamic International
Trust and investment).
 HISTORY AND DEVELOPMENT O» THE ISLAMIC BANKING SISI I M 47

While there are Islamic banks which have developed rapidly

in both Muslim and non-Muslim countries, there are also those
which have experienced failure. For example, the Muslim
Community Credit Union (MCCU), an Islamic financial
institution established in Australia in the year 2000 in the form
of a co-operative offering banking products, was closed and
suspended in the year 2002. The closure was due to losses as
a result of carelessness and unwise financing (Shaban, 2002;
www.mcca.com.au/mcca_the_mccu_story.pdf).

HISTORY OF ISLAMIC BANKING

Although the establishment of Islamic banks only became a reality

in the 1960s, this does not mean that banking activities did not
exist in Islamic history. Activities which are regarded as practices
of modem banking, such as receipt of deposits, loans issuance,
money exchange and bills of exchange, existed since the early years
of Islam and during the spread of Islam.
Before the birth of Islam, Mecca was the centre of trade and was
used as a transit point by traders passing through the city from
the north and south borders. Hence, deposit and loan activities
developed rapidly and transactions involving money exchange
became one of the main activities. These activities continued even
after Islam became rooted in Mecca and Medina. From the historical
point of view, Islamic banking can be divided into three eras. The
first era began from the early years of Islam when it was first bom
in the city of Mecca up until the period of Caliph ar-Rashidin. The
second era stretches from the era of the caliphates until the fall of
the Uthmaniyah Empire. This is followed by the third era, which is
the era of modern Islamic banking.
48 CHAPTER 2

Early Era of Islamic Banking System

Islam was bom in Mecca when the Prophet Muhammad (p.b.u.h.)
first received divine revelations of Islam in the year 610 at Mount
Hira', and Islam was consequently preached openly in the year 613
at Mount Sara. Before that time, Mecca was a city of trade, and its
business activities continued even after Islam became rooted there.
Among the banking activities that remained in operation was the
safe-keeping of money and valuables. These savings transactions
were made by those with wealth, and savings were entrusted to
reputedly highly trustworthy persons. The depositors would
choose only persons of proven honest)’ and sincerity in keeping
and returning their valuables. Prophet Muhammad (p.b.u.h.) was
one person renowned for his honesty and trusted by the people.
He remained custodian of other people's deposits until his
migration from Mecca to Medina. Before his departure, the Prophet
(p.b.u.h.) appointed Sayidina Ali to return all the deposits to their
rightful owners (Homoud, 1985).
Both before and after the arrival of Islam in Mecca, deposits were
made for safe-keeping, lire person entrusted to keep the deposit
would pledge to return the amount deposited. However, during the
time of the Prophet (p.b.u.h.), one of his Companions, Az-Zubair
al-Awwam would refuse money from depositors if it was in the
form of savings. Instead, he preferred it to be in the form of a loan
or yard. Abdullah az-Zubair explained that when people came
to his father with money for him to help keep, his father would
maintain that the money was a loan and not a deposit, because he
feared that if it was in the form of a deposit, it could go missing.
Az-Zubair's action was a wise one; it covered two objectives. First,
by treating the deposit as a loan, he had the right to use it. Secondly,
if the deposit was not used, it would actually be a loss to its owner.
On the other hand, as a loan, the deposit was safer, because it
represented a secure guarantee to the owners since the borrower
was liable to return the deposit to the depositors.
 HISTORY ANO DEVELOPMI NT Of HIT IStAMK BANKING SYSTEM 49

The history of early Islamic banking through the story of

Az-Zubair depicts the change in the concept of deposit, which
was originally in the form of trust, to that of loan. Moreover, the
deposit facility was not for a particular person or group of persons,
but instead it was a public facility. The number of depositors was
evidently big; because on the death of Az-Zubair, his son, Abdullah
Az-Zubair was hesitant about distributing his father's assets among
his siblings even after paying back all of his father's dues. Instead,
for the duration of four hajj seasons Abdullah made announcements
urging those who had deposited with Az-Zubair to come forward
and reclaim their money from him. Only after the four hajj seasons
did he distribute his father's assets. The community of Mecca at
that time only knew two uses of money: first, to entrust money to
someone else for it to be used in business based on the qirad or
ntudharabah principle and then to share the profits of the transaction;
and secondly, to loan out money in order to obtain interest or riba.
The practice of riba was widespread before the emergence of Islam,
both among Arabs and between Arabs and Jews who were then
living in the Arabic peninsula.
With the arrival of Islam, the practice of riba was no longer
permitted. Nevertheless, this prohibition did not pose a hindrance
to the conduct of daily life as well as trade development. Besides
this, the practice of exchange of items or money also existed during
the early years of Islam. The Prophet (p.b.u.h.) on many occasions
had to resolve problems pertaining to money exchange. This is
evident from one Haditli narrated by Abu al-Minhal: "/ asked al-Rara
bin Azib and Zaid bin Arqam about practicing money exchange. They
replied, ‘We are traders in the time of Allah's Apostle (p.b.u.h.) and I asked
Allah's Apostle about money exchange. He replied, "If it is from hand Io
hand, there is no harm in it; otherwise it is not permissible.(Khan,
1989, p. 157).
In addition, transactions involving money exchange during the
early days of Islam did not only entail the exchange of one currency
for another; there were activities similar to what is known in today's
50 CHWTIK2

banking system as money order. It has been said that rbn al-Abbas
received the warik (a type of currency that originated from silver
and melted down to become dirham, which is a 3.0 gram coin of
pure silver) and sent an acknowledgement to Kufah, a mediaeval
city of Iraq. Similarly, Abdullah Az-Zubair received money from
the Mecca community and subsequently wrote a receivable
acknowledgement to his brother, Mis'ab bin Az-Zubair in Iraq who
repaid the depositors when they arrived in Iraq.

Middle Era of Islamic Banking System

The middle era of Islam began with the end of the reign of
Caliph Uthman in the year 661 AC. What followed was the reign of
Caliph Umaiyyah (661-750) with Damsyik as the centre, followed
by the reign of Caliph Abbasiyvah (750-1258) which was centred
in Baghdad, the reign of Caliph Umaiyyah in Spain (756-1031) and
the period of the Uthmaniyah Empire (1350-1918).
The middle era of Islam witnessed the continuation of
banking activities which were practised in the early era of Islam.
For instance, the transfer of money as practised by the sons of
Az-Zubair became the norm among money changers. Apart from this,
during the middle of the fourth Hijrah century a new development
emerged in the history of Islamic banking. I lomoud (1985) extracted
a story from the first part of the book Zuhr ul-lsluiri written by
Ahmad Amin. According to the book, Saif Dawala al-Hamadani,
who was Amir of Aleppo, issued cheques during his visit to
Baghdad. While in Baghdad, Saif visited a local shop Bani Khaqan
for a drink and upon leaving the shop he asked the owner for a
piece of paper on which he wrote the name of the money changer
together with the amount that he owed. 1,000 dinar. The paper was
then exchanged by (he shop owner for the stated amount of money
as written by Saif. When asked by the shopkeeper who it was who
 IIISIOIO AND DEVEIDI-MIM Ol1 THE IMAMU HANkINE. MSIIM 51

wrote on the paper, the money changer replied that the person was
the Amir of Aleppo, Saif Dawala al-Hamadani.
The usage of cheques for trade purposes was also a norm in
the city of Basrah for which regulations had been formulated
for matters related to seals and witnesses. Around 400 H or
1010 AC, Basrah flourished with the activities of money changers.
During that period, ships and Muslim traders were travelling to
and fro between countries to trade, in his book titled Safarnama,
Naser Khasro, a Persian traveller, recounted his travel experiences
between 437 11 and 444 H. During his visit to Basrah, he described
that markets were set up in three different venues every day.
In the morning, trading took place in Khaza, while activities moved
to the Uthman market at midday and at nightfall trading shifted
to Qaddahin. Trading and business activities carried out in each
market were conducted using cheques issued by money changers.
These cheques were then used to purchase whatever the buyers
needed. Nonetheless, buyers could only use such cheques as long
as they resided in the city of Basrah.
The fall of the Roman Empire at the end of AD 400's and
the occurrence of the Dark Ages which swept Europe (from
the 5th to the 10th century) had a significant adverse impact on
the economic activities of Muslim countries. It was not until
tlie revival of the economies of the European countries in the
12th century and the resurrection of the conventional banking
system that the conventional banking system expanded beyond the
shores of the European continent to make its debut in the Muslim
countries. Although Islamic banking failed to expand during this
era, development took place in terms of fatwa (legal opinions)
by Muslim jurists pertaining to issues of muamalat, particularly
those involving riba. This was the era of many renowned jurists or
ulama such as Imam al-Azam Abu Hanifah (60 H/698-150 H/767),
Imam Malik ibn Anas (93 H/7I2-179 H/795), Imam Ahmad ibn
Hanbal (164 H/778-241 H/855) and al-Shafii (150 H/767-20411/820),
who were the founders of the Hanafi, Maliki, Hanbali and Shafii
52 CHATTER 2

schools of thought. The views of these ulainn, particularly on the

subject of muamalat, have become the reference point for ulama in
the modem era of Islamic banking in giving their opinions and
judgements related to Islamic banking activities such as whether
the conduct is lawful and in accordance with Syariah principles or
otherwise.

Era of Modern Islamic Banking

The development of the Islamic banking system may have started
with the establishment of Mit Ghamr Savings Bank, but this does
not mean that no earlier attempts were made to establish Islamic
financial institutions. Some parties believed that the first attempt
to establish an interest-free bank was made in Malaysia in the
mid-1940s (Erol and El-Bdour, 1989). However, this organization
which was founded on Syariah principles was unsuccessful.
Another such attempt took place in a rural area of Pakistan in
the late 1950s. This local institution did not charge interest on its
lending (Wilson, 1983).
The establishment of Mit Ghamr Savings Bank in one of the
rural regions in the Nile Valley in Egypt marked the dawn of the
modern era of the Islamic banking system and paved the way for
the establishment of other Islamic banks. This bank provided basic
banking services such as deposit accounts, loan accounts, equity
participation, direct investment and social services. The services
founded on Syariah principles provided by the bank were very well
received by the local community and the farmers. The number of
depositors increased tremendously from 17,560 depositors in its
first year of operation (1963/1964) to 251,152 depositors at the end
of the 1966/1967 financial year. Similarly, the amount of deposit
increased from LE40.944 (Egyptian pound) at the end of its first year
of operation to LEI,828,375 at the end of the 1966/1967 financial year.
The bank was successful in preventing customers from going to
 HISTORT AND DEVELOPMENT OF lilt ISLAMIC BANKING SIS I LM 53

money lenders for financial assistance. Another factor contributing

to the success of Mit Ghamr Savings Bank was its ability to instil a
sense of belonging among its customers. However, due to political
unrest in Egypt, its operation suffered a setback. In mid-1967, its
operations were consequently taken over by the National Bank
of Egypt and Central Bank of Egypt- As a result of this action, the
interest-free concept was abandoned and Mit Ghamr's operations
reverted to an interest-based system. However, the interest-free
concept was revived in 1971 under the rule of President Anwar
al-Sadat and a new financial institution by the name of Nasser
Social Bank was established.
Although Mit Ghamr Savings Bank had to cease operations
prematurely and before it was able to extend its services to all
business sectors, it nevertheless signalled to the Muslim community
that Islamic principles were applicable to modern-day business. This
phenomenon stimulated many Muslim scholars around the world
to embark on studies related to interest-free banking as practised
by Mit Ghamr Savings Bank. However, the scarcity of literature and
the non-existence of a comprehensive set of guidelines in Syariah
caused frustration among the Muslim scholars. Nevertheless, these
setbacks were not considered hindrances for those who wanted
to go back to religion. The revival of the spirit of Islam sparked
renewed interest in Islamic banking and inspired Muslim scholars
to continue their efforts to establish Islamic banks in their respective
countries. Acknowledging the scarcity and unavailability of proper
guidelines concerning principles and practices of interest-free
banking, they decided that the first task was to formulate guidelines
and frameworks on practical aspects of Islamic banking system.
This task was rightly vested in tire hands of Islamic theologians and
economists.
However, it was a daunting task finding Muslim economists
who were also well versed in the knowledge of Syariah laws.
More often than not, those who possessed in-depth knowledge
in economics did not have knowledge in Syariah, and vice versa.
54 CHA1TTK 2

To make matters worse, most .Muslim economists were educated

in Western economies and did not possess strong fundamentals
in Islamic economics. For example, when President Zia ul-Haq
set up a task force to study and formulate a framework for the
introduction of Islamic banking system in Pakistan, only 1 out of the
19 appointed members could be regarded as an expert on Islamic
economics. Eleven of them had merely received education from the
rnaiirasa or religious school (Gieraths, 1990).
The need to establish banks founded on Syariah principles
reached its peak around the 1970s. The first steps in the establishment
of Islamic banks were usually taken by private initiatives rather
than the government. Moreover, the process of tire establishment
of such banks varied from one Muslim country to another. The late
Saudi Arabian King Faisal bin Abdul Aziz al-Saud was one of the
noteworthy individuals who played a significant role and made a
major contribution to the development of Islamic economics and
Islamic banking. His Majesty initiated the establishment of the
Organization of Islamic Conferences (OIC) and urged Muslim
countries to set up their own Islamic banking system (Ali, 1988).
The establishment of the Islamic Development Bank (IDB) in 1975
was seen as an impetus for the establishment of other Islamic
banks in various Muslim countries. For example, Dubai Islamic
Bank, which was the first private interest-free bank, was set up
in the same year as IDB. In 1977, three more Islamic banks were
incorporated, namely Faisal Islamic Bank of Egypt. Faisal Islamic
Bank of Sudan and Kuwait Finance House. Islamic banks set up
in the 1970s and early 1980s are as shown in Table 2-1. In South
East Asia, the establishment of financial institutions that adopted
terminologies resembling the operations of Islamic financial
institutions commenced in the Philippines. Phillipine Amanah Bank
was established in 1973 by Preshlcntial Decree No. 263 issued by the
then President Ferdinand Marcos (www.islamicbank.com.ph).
 HISTORY AND DEVELOPMENT Ol 1HI ISLAMIC HANKING SYSTEM 55

TABLE 2-1 Islamic Banks Set Up in the 1970s and 1980s

Name Country
. establishment
Nasser Social Bank Egypt 1972
Islamic Development Bank Saudi Arabia 1975
Dubai Islamic Bank United Arab 1975
Emirates
Faisal Islamic Bank of Egypt Egypt 1977
Faisal Islamic Bank of Sudan Sudan 1977
Kuwait Finance House Kuwait 1977
Islamic Banking System Luxembourg 1978
International Holdings
Jordan Islamic Bank Jordan 1978
Bahrain Islamic Bank Bahrain 1979
Dar al-Mal al-lslami Switzerland 1981
Bahrain Islamic Inv. Company Bahrain 1981
Islamic International Bank for Egypt 1981
Investment & Development
Islamic Investment House Jordan 1981
Albaraka Investment and Saudi Arabia 1982
Development Company
Saudi-Philippine Islamic Saudi Arabia 1982
Development Bank
Bank Islam Malaysia Berhad Malaysia 1983
International Islamic Bank Bangladesh 1983
Islamic Bank International Denmark 1983
Tadamon Islamic Bank Sudan 1983
56 CHATTCK 2

TABLE 2-1 (continued)

Year of
establishment
Qatar Islamic Bank Qatar 1983
Bait Ettamouil Saudi Tounsi Tunisia 1984
West Sudan Islamic Bank Sudan 1985
Albaraka Turkish Fin. House Turkey 1985
Faisal Finance Institution Inc. Turkey 1985
Al-Rajhi Company for Saudi Arabia 1985
Currency Exchange &
Commerce
Al-Ameen Islamic & Financial India 1985
Inv. Corp. India Ltd.

Source: Haron and Shanmugam, 1997.

Most of the Islamic banks mentioned in Table 2-1 have now been in
operation for more than 30 years. These banks have not only been
able to offer facilities similar to that of conventional banks, but thev
have in fact shown commendable performances with most of them
generating profits. Apart from this, Islamic banks have attracted
non-Muslims to patronize them. Even though Islamic banks in
the Muslim countries were set up on private initiatives, the full
support of governments is essential in guaranteeing the success of
the banks. Countries such as Pakistan. Iran and Sudan, for example,
have completely Islamized their banking systems. Other Muslim
countries operate a dual-banking system whereby both Islamic
and conventional banks operate parallel to each other. In countries
where the government lends full support, development of the
Islamic banking system is better planned and progress has been
rapid. On the other hand, slow progress is observed in countries
where the involvement of the government is limited. In Malaysia.
 msroRv ano Dt:vi iofmi N’r <>i mr Islamic banking swum 57

for example, the full support of the government has paved the
way for the rapid development of Islamic banking in the country.
In early 1993, a total of 21 banking services based on Syariah
principles were developed by the Central Bank of Malaysia or Bank
Negara Malaysia. By the end of the same year, a total of 21 financial
institutions had participated in the Interest-free Banking Scheme.
Significant development of the Islamic banking system
in Malaysia was achieved when an Islamic inter-bank money
market was established in early 1994. This system involves the
inter-bank trading of Islamic financial instruments, Islamic
inter-bank investments and Islamic inter-bank cheque clearing
system (Bank Negara Malaysia. 1994). This Islamic inter-bank
money market has facilitated banks in Malaysia to venture into
investments or short-term loans among themselves in accordance
to Syariah. To further spur the growth of the Islamic banking
system, the Malaysian government launched the Financial Sector
Master Plan 2001-2010 in 2001. The Master Plan contains a strategic
blueprint for the development of the country's financial system
with the development of Islamic banking as one of its objectives.
In an effort to promote active trading and expand the use of Islamic
financial instruments to the international level, Malaysia once again
took the helm when it cooperated with Bahrain, Brunei, Indonesia
and the Islamic Development Bank to establish the International
Islamic Financial Market. This institution, which was established
under a Royal Decree and headquartered in Bahrain, commenced
operations on 1 April 2(X)2. Founding members include the Islamic
Development Bank, Bahrain Financial Authorities, Labuan Offshore
Financial Services Authority, the Central Bank of Sudan, the Central
Bank of Indonesia and Brunei Finance Ministry. Other members of
the organization include the Central Bank of Iran, Kuwait Finance
House, Abu Dhabi Islamic Bank and Shamil Bank of Bahrain.
Since the objectives and operations of Islamic financial
institutions differ from those of their conventional counterparts,
consequently their methods of accounting and auditing also differ
from the conventional ones. Hence, in line with the aim to create
uniformity in the accounting and auditing practices in the Islamic
finance industry, the Accounting and Auditing Organization
for Islamic Financial Institutions (AAOIFI) was established on
27 February 1990, corresponding to 1 Safar 1410 11. in Algiers,
Algeria. This organization was registered in Bahrain on 27 March
1991 corresponding to 11 Ramadhan 1411 H. Another development
in international-level Islamic banking was the establishment of the
Islamic Financial Services Board (IFSB). The IFSB, which is based
in Kuala Lumpur, was officially inaugurated on 3 November 2002
and began operations in March 2003. There are three categories
of membership, namely full membership, associate membership
and observer membership. In 2008, there were 21 full members,
21 associate members and 136 observer members (www.ifsb.org).
Dr. Ahmad Mohamed Ali, President of the Islamic Development
Bank, in his working paper presented at the Fifth Forum on Islamic
Finance 2002 at Harvard University, USA, divided the development
of Islamic banking and financial institutions into six phases.
The first phase, which took place in the 1950s, is regarded as the
starting point of Islamic finance and banking. During this period.
Islamic intellectuals began giving their views on concepts of Islamic
banking to replace conventional banking systems. The suggested
outline of the Islamic banking organization was based on the
concept of twin mtidharabah. The 1960s saw the emergence of early
institutions of Islamic banks like Mit Ghamr Savings Bank in Egypt
in 1963 and Lembaga Tabling Haji in Malaysia in 1966. The period
of the 1980s was the most active phase in terms of the development
of Islamic banking systems. During this decade, many banks were
established and new products introduced. Conventional banks also
showed interest in providing Islamic banking services through the
window concept. In addition, with the aim of extending knowledge,
many research programmes, teaching and training related to this
branch of knowledge were introduced in institutions of higher
 HISTORY AND DEVELOPMENT OF THl ISLAMIC RANKING SYSTEM 59

learning. The development and growth of Islamic banks worldwide

was made even easier when the International Monetary Fund
participated in research activities and with the publication of articles
on Islamic banking. Trust funds founded on St/ariah principles were
also launched. The 1990s witnessed the development of Islamic
banking in the American capital market, where the Dow Jones
Islamic Index was launched. In addition, accounting standards on
Islamic banking were issued by AAO1FI. Events that occurred in
various phases are shown in Table 2-2.

DEVELOPMENT OF ISLAMIC BANKING

SYSTEM IN SELECTED COUNTRIES

Currently, Islamic banks are operating in most Islamic countries.

However, the experiences of the banks differ from one country
to another. Differences are found in aspects such as history of
establishment, laws to be abided by, and opportunities and support
from the governments concerned. Islamic banks would not be faced
with problems if the governments of the countries concerned are
truly committed to developing Islamic banking systems. Due to the
differences mentioned earlier, a brief description will be given of the
establishment of Islamic banks in selected countries. Egypt is chosen
because it is where the history of Islamic banks began. In Sudan,
Islamic banks received special treatment in the beginning, but later
with a change in the ruling government, the special treatment was
withdrawn. Turkey has a secular form of constitution and regards
religion as separate from politics. Iran and Pakistan have changed
their entire banking systems to Islamic banking systems. Malaysia
is regarded as a country committed towards establishing the Islamic
banking system.
60 chapter 2

TABLE 2-2 Development of Islamic Financial and Banking

Institutes According to Specific Periods

1950s • Islamic scholars and economists began presenting

models of banking and financial systems to replace
banking based on interest rates.
• A twin Mudbarabah concept suggested as model for
Islamic banking.
1960s • The practice of Islamic financing principles began.
• Operation mechanisms for Islamic financial
institutions were recommended.
• Rise and fall of Mit Ghamr Savings Bank in Egypt.
1965-1967.
• Establishment of Lembaga Tabling Haji in Malaysia.
1966.
1970s • Islamic banks and Islamic non-bank financial
institutions were established.
• Academic activities began to be organized.
• Academic institutions were set up.
• Mudharabah financial mechanism began to be
established.
• Establishment of Islamic Economic Research Centre,
Jeddah.
• Start of publication of books on Islamic banking.
Topics covered were profit-loss sharing, mudluirabah
and leasing.
• Establishment of Dubai Islamic Bank, 1975.
• Opening of Islamic Development Bank. 1975.
• First International Islamic Economics Conference
held in Mecca in 1976.
 HISTOKt ANTI DEVELOPMENT OF Fill ISLAMIC BANKING MS! I M 61

TABLE 2-2 (continued)

1980s • Government intervention in promoting Islamic
banks.
• Setting up of more private sector banks.
• A variety of Islamic banking products introduced.
• Increased interest among academicians and
financial groups in the West in Islamic banking.
• Conventional banks began to make available the
window concept that offers Islamic products.
• Increase in research programmes, teaching and
training.
• Growth of Islamic index and trust funds.
• Pakistan. Sudan, Iran, Malaysia and other countries
attempted to change their banking systems or to use
the Islamic system.
• IMF published working papers and articles on
Islamic banking; research and publication on
Islamic banking flourished.
• Establishment of Fiqh Academy of OIC and other
Fiqh Boards.
• Establishment of Islamic trust funds throughout the
world.
62 CHAl’TtK 2

TABLE 2-2 (continued)__________________________________

1990s • Growth in the Islamic window concept.
• Enhancement in asset-based financial instruments,
recognition of the importance of Islamic financial
institutions and banks.
• Establishment of Islamic Index at Dow Jones and
the Financial Times.
• Regulations and supervision given attention.
• Standards of AAOIF1 issued.
• Start of task of establishing support institutions.
Early • Continuous growth and maturity alongside risk
2000s challenges.
• Completion of the architecture of Islamic finance.
• Attention on risk management and corporate
control.
• Capitalization of Islamic banks through mergers.
• Creation of an asset-backed securities market.
• Islamic Financial Services Board, Malaysia formed
in 2002.
• Establishment of the International Islamic Rating
Body, Bahrain.
 HISTORY AND DEVELOPMENT Or THE 1SI AMIC BANKING SYSTEM 63

History of Islamic Banking System in Egypt

The history of the establishment of Islamic banks in Egypt
started with the establishment of Mit Ghamr Savings Bank in
1963, followed by the establishment of Nasser Social Bank in
1972, Faisal Islamic Bank in 1977 and International Bank for
Investment and Development in 1980. The establishment of
Mit Ghamr Savings Bank by Ahmed al-Naggar is regarded as the
milestone in modem Islamic banking. Mit Ghamr Savings Bank
offered five types of banking services based on Syariah principles.
These services comprised deposit accounts, financing accounts,
equity participation, direct investment and social services.
Tile bank offered two types of deposit accounts, savings account
and investment account. The savings account did not offer any
returns or riba, while the investment account was based on the
concept of profit and loss sharing. Similarly, there were two types
of financing facilities, non-investment financing and investment
financing.
Non-investment financing is the type of financing provided to
clients who maintain a savings account in the bank. There is no
charge incurred on the borrower. The borrower only needs to pay
back the amount borrowed. Investment financing, on the other
hand, is financing given out particularly to small entrepreneurs,
under the concept of profit and loss sharing. Repayment of the
financing is done either at the end of the financing period or in
instalments. Equity sharing is the concept whereby the bank acts as
a business partner and contributes the initial capital for an intended
enterprise. Allocation of profit is based on the ratio of the capital
issued or on the ratio agreed upon by the bank and the partner
concerned. In direct investment, the bank itself issues capital and
starts a business. Social services are services provided by the bank
in the collection of zakat and in channelling the zakat to goodwill
projects and society.
With the existence of Mit Ghamr Savings Bank, the inhabitants
of the interior regions of the Nile Valley no longer needed to rely on
64 < HArrm 2

financing by lenders who imposed high rates of riba. The farmers

had the burden of their debts lightened. This success of Mit Ghamr
received praise and the recognition from the Ford Foundation.
In its report issued in June 1967, the Ford Foundation applauded
the success of the bank in winning support from farmers and
villagers (El-Ashker, 1990). The growth in the number of depositors
and deposit amount is Shown in Table 2-3. It can be seen that growth
was highly encouraging during the four years of its operations.
Total number of depositors increased by 73% for 1964/65 and
subsequently by 400% and 65% for 1965/66 and 1966/67, respectively.
The total deposits meanwhile increased by 367% for 1964/65. 360%
for 1965/66 and 108% for 1966/67.

TABLE 2-3 Number of Depositors and Total Deposits for

Mit Ghamr 1963/1964-1966/1967

Year Total depositors Total deposits

1963/1964 17,560 40,944
1964/1965 30,404 191,235
1965/1966 151,998 879,570
1966/1967 251,152 1,828,375

Source: El-Ashker, 1990. p. 61.

However, due to changes in the political climate of Egypt, its

operation suffered a setback and it was taken over by the National
Bank of Egypt and Egypt Central Bank in mid-1967 and subsequently
riba was introduced into the operations of Mit Ghamr. This change
from Islamic banking system to a ril'n-based system reduced the
number of depositors substantially. Nevertheless, the concept of
Islamic banking was revived in 1971, under the rule of President
Anwar al-Sadat when the government established the Nasser Social
Bank in 1972. Even though the operations of Nasser Social Bank are
 HISTORY AND DEVIIOFMtM OF THE ISLAMIC BANKING SYST1 M 65

similar to those of Mit Ghamr Savings Bank, the former offers a full
range of banking services and a wide range of investment activities
including foreign exchange services. Unlike Mit Ghamr whose
establishment was under private initiative, Nasser Social Bank
received full government support as well as government subsidies
in maintaining its financing operations.
Apart from Nasser Social Bank, two other Islamic banks were
established in Egypt at the end of the 1970s, namely Faisal Islamic
Bank of Egypt (FIBE) and Islamic International Bank for Investment
and Development. FIBE is a joint venture between Saudi Arabia
and Egypt. It was incorporated under a special act, that is, Law No.
48/1977. This Law confers on FIBE a special status and provided the
bank with special privileges from the government. However, the
bank comes under the supervision of the Central Bank of Egypt.
The Law also outlines the total capital allowed and has enacted total
shares be 51% owned by Egypt and 49% by Saudi Arabia. However,
the Law allows Saudi Arabia to sell its allocation to other Arab
parties as well as to non-Muslims in Egypt. FIBE is also subject to
three other acts, namely Company Act, Investment ofArab and Foreign
Funds Act, and Banking and Control Act.
The Islamic International Bank for Investment and Development
(IBID) was established in 1980 through a Ministerial Decree, in line
with the requirements of the Investment Law of Arab and Foreign
Funds and Free Zones Law (number 43) of 1974. Unlike FIBE, IBID
which began its operations in October 1981, is wholly owned by
the Egyptians.
Both FIBE and IBID offer services which are almost similar to
those of commercial banks. FIBE offers current account services
without overdraft facilities. Savings account services are not
provided, but customers could open investment accounts for specific
durations where returns are on a profit-sharing basis. FIBE also
provides two types of financing, namely short-term financing, and
medium and long-term financing. Short-term financing is normally
based on the principle of murabaha/i, while medium and long-term
66 CHATTIR 2

financing are mostly based on the musyakarah principle. FIBE is also

involved in business, either through equity participation or through
its subsidiary companies.
In terms of social services, FIBE contributes towards the
advancement of Islamic economy by actively organizing seminars
and conferences, financing publications related to Islamic economics
and setting up its own library. All these social activities are funded
by FIBE through its own fund set up primarily for these purposes
or money from zakat. Unlike FIBE, IBID provides savings account
facility to its customers. In addition. IBID has also introduced
a facility known as Investment Savings Accounts to encourage
depositors to invest but at (he same time they could withdraw
part of their savings at any time if required. This differs from the
normal investment account where an investor is not allowed to
withdraw his money before it is due. However, returns for both
types of deposit are on a profit-sharing basis. IBID also provides
financing facilities for various projects involving the agricultural,
industrial and commercial sectors. These financing facilities may be
short-term, medium-term or long-term and are normally based on
the principles of inudharabah and musyarakah.
In June 2006. the Central Bank of Egypt decided to merge IBID
with two conventional banks. United Bank ot Egypt and Nile Bank,
to form the United Bank in an attempt to restructure the banking
system. The decision to merge these three banks was made in order
to solve their financial problems. For instance. IBID had not only-
struggled with high debts for a number of years but also failed to
increase its paid-up capital to a new minimum of EE500 million
under the capital adequacy requirements imposed bv the Central
Bank of Egypt in 2005.
The United Bank is 99.9% owned by the Central Bank of Egypt
and is now the third largest banking entity in the country. The
United Bank has 34 branches of which 7 are Islamic branches. This
new bank provides traditional banking services as well as Islamic
banking products and services. Among the traditional banking
 HISTORY AND DEVELOPMENT OP IUt IMAMIC HANKING SYSTEM 67

products and services offered are investment accounts, savings

accounts, postponed deposits, traditional certificates, credit cards, safe
deposit boxes, remittances services, brokerage services and crediting
employees' salaries to their bank accounts (www.theubeg.com).
The bank's investment account is equivalent to term deposit
with variable return and depositors are only allowed to withdraw
their deposits after three months. Savings accounts comprise
investment savings account, general savings account, savings
book of pilgrimage and umrah and the US Dollar savings account.
In terms of traditional certificates. United Bank offers the diamond
certificate (a three-year certificate with a fixed return), the golden
certificate (a three-year certificate with cumulative fixed return),
the five-year certificate with a fixed return, the three-year certificate
in US Dollar with a fixed return and the millionaire certificate
(Syarfaft-compliant certificate).
The United Bank also offers Islamic banking services under the
name "Rakha'a" which means prosperity. This sector was created as
a result of the merger between the branches of IBID and the Islamic
Syariah transactions branches of the United Egyptian Bank and Nile
Bank. Under its Islamic banking sector, the bank applies concepts
such as musyarakah, mudharabah, murabahali, bai salam, istisna, bai
ajil and ijarah in its financing and investment portfolio. The bank
also offers the "Dyar" Islamic Real Estate Financing Sendees which
provide Sl/ariflh-bascd financing for purchasing a house, renovating
the house or for building a house. Under these financing schemes,
the bank applies murabaliah concept for short- and long-term
financing of between 1 and 15 years.
Another Islamic bank in Egypt is the Egyptian Saudi Finance
Bank (F.FSB) which is a subsidiary unit of the AlBaraka Banking
Group. The EFSB has 18 branches and offices throughout Egypt
and offers various types of SjMrw/t-compliant banking sei-vices
including retail banking, foreign trade services, letters of credit
savings pools, investment trustees, instrument umrah as well as
mutual funds, securities and custody. The EFSB also fulfils its social
68 CHATTtR 2

obligation through the operation of its zakal funds and social fund
for development. The latter fund is used to finance development
projects for new and small enterprises. The bank provides medium-
and long-term financing for various economic activities involving
the telecommunications sector, airports and air transportation
sector, public garages sector, medicine and medical requirements
sector, exporting industries sector, industry sector, tourism sector
and oil sector.
Although Egypt was among the first country to establish an
Islamic bank, it has in recent years lagged behind in the development
of an Islamic banking system compared to countries like Bahrain and
Malaysia. The combined market shares of Islamic banks in Egypt
constitute only 5% of the total banking system. One of the main
factors cited as to why Egypt has fallen behind in the development
of Islamic banking is the high profile scandals of Islamic investment
companies in the 1980s. According to El-Gamal (2006), the failure
of Islamic Money Management Companies in Egypt in the 1980s
has somewhat damaged the public perceptions of Islamic banking
in the country. By 2008, there were two Syarw/i-based financial
institutions in Egypt (Faisal Islamic Bank of Egypt and Egyptian
Saudi Finance Bank) and 13 conventional banks operating Islamic
windows. Nonetheless, only 128 branches of the thousands of
branches operated by these 13 conventional banks offered Islamic
products (www.sukuk.net).

History of Islamic Banking System in Sudan

The development of Islamic banking in Sudan is somewhat unique
compared to that in other Muslim countries. This is due to the fact
that Islamic banking in Sudan underwent two distinct periods: a
period of full government support and a period of distress in the
banking sector. During the first period, Islamic banking enjoyed
encouragement and full support from the government. This period
 HISTORY AND DEVELOPMENT Ol- THE ISLAMIC BANKINC. SYSTEM t>9

saw the rapid development of Islamic banking in Sudan and most

of the regulations imposed were in support of the rapid growth of
the banks. However, when this support was withdrawn, banks in
Sudan were faced with obstacles ancj had to comply with regulations
which hindered their growth.
The concept of Islamic banking was introduced in Sudan with
the establishment of Faisal Islamic Bank of Sudan (FIBS) in 1977.
The FIBS was established under a special law known as the FIBS
Act of the National People's Council and began operations in May
1978, Initially, FIBS enjoyed a range of facilities and was exempted
from various regulations such as regulations on banking services,
insurance, auditing and tax on profits. These privileges were
however withdrawn when the government Islamized the entire
banking system in Sudan in 1984. As with other Islamic banks, the
FIBS offers deposit facilities, which include savings account, current
account and investment account. These facilities are based on the
principle of profit sharing. For financing facilities, the principles
practised include mudharabah, musyarakah and murabahah. The
initial success of FIBS spurred the government to support the
establishment of more Islamic banks. Consequently, three more
Islamic banks were created in 1983, namely Tadamon Islamic Bank,
Sudanese Islamic Bank and Islamic Cooperative Development
Bank. In 1984, two more banks began operations, Albaraka Bank
(Sudan) and Islamic Bank for Western Sudan.
In September 1983, the government of Sudan launched its
Islamic laws and the whole banking system was required to convert
its operations to be in line with Syariah principles. By September
1984, the entire banking system in Sudan was supposed to operate
in accordance with Syariah principles. In actual fact, however,
conventional banks continued to practise interest-based banking
activities. This resistance to the Islamization process of the banking
system not only came from the conventional banks, but also from
the authorities at the Central Bank of Sudan. When the government
which wanted to Islamized the banking system was overthrown.
70 CHAIHCK2

all the conventional banks ceased to offer products and services

based on Syariah principles. Only Islamic banks continued to offer
such services. The government made the decision to re-lslamize
the entire banking system in Sudan in 1991. It was reported in the
media that the transformation process this time was done in a more
sincere and organized manner (Ahmad, 1994).
In 2005, a peace agreement called the Comprehensive Peace
Agreement (CPA) was signed by the Government of Sudan and
the Sudan People's Liberal Movement in the South. The signing of
this peace deal ended decades of civil war which erupted in 1983.
With the signing of the CPA. the Central Bank of Sudan Act 2002 was
amended in 2006. Under Section 5 of the Act, the banking system
in Sudan consists of a dual banking system with Islamic banking
continuing to operate in the North and conventional banking
operating in the South. The Bank of Southern Sudan (BOSS), a
branch of the Central Bank of Sudan, was established to regulate
and supervise the conventional banks as well as branches of Islamic
banks in the South. Even though the South is given autonomy on
its banking system, both conventional and Islamic banks adopt
only one national monetary system (Mohamed Rajab, 2006). By the
end of 2007, there were 32 banks operating in Sudan with 8 Islamic
banks and 2 conventional banks operating in Southern Sudan
(Central Bank of Sudan, 2007).

History of Islamic Banking System in Turkey

Although 99'!., of the population in Turkey are Muslims, the country
does not recognize itself as a Muslim country. Instead, Turkey has
chosen to become a secular country 1'his change started in 1928
when Mustafa Kamal At-Taturk , founder of modem Turkey, held
the notion that the advancement of Turkey could only be achieved
by emulating Western models and by separating religion from all
other things. This situation has perpetuated until today. In Article 2
 IIISIORt AND DEVELOPMENT Of Tilt ISLAMIC BANKING SISIIM 71

of the country's constitution, it is stated that Turkey is a democratic,

secular and socialist nation. Article 24 clearly states that religion
must be kept separate from politics, social matters, economy, laws
and other matters associated with the country, and religion is only to
be used for personal purposes. In the 1960s, the government's view
regarding religion began to soften as a result of three main factors.
First, the western-educated elite had started to accept the presence
of Islam and had allowed the establishment of political parties
founded on Islam in Turkey. Secondly, the government consented
to education centred on religion. As a result, since 1965, about 10%
of secondary schools and 40% of upper secondary schools in Turkey
are Islamic religious schools. The third factor was the rise of Islamic
movements in the Middle Eastern countries, and it was these Middle
Eastern countries which mostly financed the religious activities in
Turkey. In addition to this, a number of the Organization of Islamic
Conference member countries, as well as the Islamic Development
Bank had pressured the Turkish government to open its door to
Islamic banks in the country.
As a result of the factors mentioned above, during the 10th
general election in 1983, the Turkish government pledged to
promulgate special laws to allow the establishment of Islamic
banks in Turkey. The Prime Minister of Turkey at that time, Turgut
Ozal. was of the view that individuals should be given the choice to
patronize their preferred banking institutions. Turgut Ozal's consent
for Islamic banks to operate was also the Prime Minister's bonus to
his supporters who were faithful followers of Islam (Bald win, 1990).
Even so, this move was met with varying opposition especially from
those of hard core secular stand and from prominent figures of the
conventional banks.
Tlie decree of a special law. Decree 8317506 on 16 December
1983, which was later published as Official Gazette No. 18256 on
December 1983, paved the way for the establishment of Islamic
banks in Turkey. This Law consists of 17 articles and describes
the methods, rules of establishment, permissible activities and
72 CHATTV.R 2

other associated matters that must be complied with by Special

Finance Houses (these are financial institutions established to
provide only interest-free financial products and services). In
addition, comprehensive rules and regulations were issued by
the Undersecretariat of the Treasury and Foreign Trade through
Official Gazette No. 18232 dated 25 February 1984. The regulations
issued comprise 35 articles and cover various aspects related to
the establishment, operations and liquidation related to Islamic
banking such as total capital required for establishment, the total
number of members of Board of Directors and the types of facilities
allowed to be provided. This Law also outlines the methods of
administering the facilities provided and the wavs to calculate
profit.
Another law related to Islamic banking in Turkey was issued
by the Central Bank of Turkey. The Law was published in the
Official Gazette 18348 dated 21 March 1984. The Law comprises 18
articles, and covers matters such as regulations concerning licence,
the powers of the Central Bank in fixing liquidity ratios and the
authority of the Central Bank in regulating and supervising tire
operations of Islamic banks. Although there exist three separate
laws which Islamic banks have to comply with, all three laws do
not contain the words "Islam" or "Syariah" in them. Islamic banks
are only referred to as "Special Finance Houses". Similar!}' with
the concepts used in the facilities provided; there is no mention
of the principles of muilharabah, ntusyarakah, etc. in the regulations
issued. Syariah principles are referred to as "participation accounts"
or "profit-sharing and loss-sharing accounts". It is believed that
these acts an attempt by the government to avoid an open conflict
with the aims and principles contained in the country's constitution
(Baldwin, 1990).
At the end of 1994 there were only three Islamic banks operating
in Turkey. The first bank, which commenced operation in 1985.
was Albaraka Turk Oze! Finans Kunimu. Its biggest shareholder
was Albaraka Investment and Development Corporation from
 HISTORY AND DEVELOPMENT Of Tilt ISLAMIC BANKING SYSTEM 73

Saudi Arabia. The second bank, which also began its operations in
the same year, was Faisal Finans Kurumu or better known as Faisal
Finance Institution Incorporation and was established with capital
contributions from the Dar al-Maai al-lslami Trust group, also from
Saudi Arabia. Turk-Kuveyt Evkaf Finans Kurumu, the third Islamic
bank which started operations in 1988, was a joint-venture bank
between the Islamic Development Bank, Kuwait Finance House
and Vakiflar Bankasi. By the end of 2004, there were seven Islamic
banking institutions in Turkey, namely Albarakah Turkish Finance
House, Emin Sigorts A.S., Family Finans Karamu (formerly called
Faisal Finance Institution), Faisal Islamic Bank of Kibris Ltd., Ihlas
Finance House, Kuwait-Turket Evkaf Finance House and Asya
Finans Kurumu A.S. (www.islamic-banking.com/banking).
In November 2005, the Banking Act No. 5411 was enacted.
Under this Act, all special finance houses are transformed
into "participation banks", thus gaining the bank status.
Participation banks operate under the purview of the Banking
Supervisory and Regulator}’ Agency. In accordance with the
Banking Act. 2005, participation banks are authorized to collect
deposit under the "profit-and-loss participation accounts" and the
"special current accounts". Participation banks may also offer two
types of financing, which is murabahah and financial leasing. As at
end of 2008, there were four participation banks in Turkey, namely
Albaraka Turk, Bank Asya, Kuvyet Turk and Tiirkiye Finans.
Together, these banks held 4.2% and 3.3% share of total deposit and
total loans in the Turkey banking system, respectively as at the end
of 21X17 (www.byegm.gov.tr).

History of Islamic Banking System in Malaysia

As with other Muslim countries, Malaysia was affected by the
Islamic resurgence movement among the intellectuals especially
around the 1970s. There were calls from individuals and certain
74 CHATTER 2

groups and agencies for the government to establish Islamic banks

to cater to the needs of Muslims in Malaysia. During the Bumiputra
Economic Congress in 1980, a resolution which required the
government to allow tire Pilgrimage Board (commonly known as
Lembaga Tabung Haji) to establish an Islamic bank for the purpose
of collecting and investing money owned by Muslims was passed.
In 1981 at the National Seminar on the Concept of Development
in Islam, participants of the seminar urged the government to
promulgate a special law which would allow the establishment of
banks and financial bodies whose operations would be based on
Islamic principles.
In line with these requests, the government appointed a National
Steering Committee on Islamic Banking on 30 July 1981. It was
chaired by Tan Sri Raja Mohar bin Raja Badiozaman. The secretarial
functions were entrusted to the Pilgrimage Board. This committee
studied the operations of Faisal Islamic Bank of Egypt and Faisal
Islamic Bank of Sudan in preparing its report (Connors, 1988).
The final report was submitted to the government on 5 July 1982
and the following recommendations were made by the committee:

(i) An Islamic bank whose operations are in accordance with the

Syariali principles should be established;

(ii) Tlie Islamic bank shall be incorporated as a company under

the auspices of the Companies Act 1965;

(iii) Since the Banking Act of 1973 is not applicable for the operations
of Islamic banks, a new banking act. Islamic Banking Act 1982,
must be introduced to license and supervise Islamic banks.
Tile supervision and administration of this new Act shall be
the responsibility of the Central Bank of Malaysia; and

(iv) Islamic banks shall establish their own Syariah Supervisory

Board whose function is to ensure that the operations of
Islamic banks are in accordance with Syariah law.
 HISTORY AND DEVELOPMENT OE THE ISLAMIC RANKING SYSTEM 75

In order to pave tile way for the establishment of Islamic banks,

the Islamic Banking Act 1983 was gazetted and came into effect on
7 April 1983. This Act outlines the rules which must be conformed
to by Islamic banks that wish to operate in Malaysia, as well as
the powers of the Central Bank of Malaysia in supervising and
regulating Islamic banks in Malaysia. At the same time, the
government also passed the Government Investment Act in 1983
to empower the government to issue Government Investment
Certificates based on Syariah principles.
Tlie first Islamic bank to operate in Malaysia was Bank Islam
Malaysia Berhad (BIMB), which was incorporated under the
Companies Act 1965 on 1 March 1983 and commenced operations on
1 July of the same year. BIMB offers common products and services
that are available at conventional banks except that the bank follows
Syariah principles. BIMB also has subsidiaries whose operations are
based on Syariah principles. These subsidiary companies comprise
Syarikat A-ljarah Sendirian Berhad (a leasing company), Syarikat
Al-Wakaiah Nominees Sendirian Berhad (which provides nominee
services) and Syarikat Takaful Malaysia Sendirian Berhad. whose
main activity is to provide general insurance cover and family
insurance. BIMB was listed on the Main Board of the Kuala Lumpur
Stock Exchange on 17 January 1992. It was not until 1999 that
the establishment of a second Islamic bank was approved by the
government.
It is the long-term objective of the Central Bank of Malaysia to
create anlslamicbanking system parallel to the conventional system
This can only be accomplished through three main components.
First, the system must have sufficient number of players; secondly,
services and products must cover the whole banking system; and
thirdly, inter-bank markets where operations comply with Islamic
principles must be created.
In line with the objective to create an Islamic banking system
that runs in parallel with the conventional system, a total of
21 Islamic banking products were introduced by the beginning of
7b CHATTER 2

1993 and on 4 March 1994 the Central Bank of Malaysia launched a

scheme known as the "Interest-free Banking Scheme". Through this
scheme, financial institutions are allowed to offer Islamic banking
products and services. The pilot phase of this scheme involved the
three largest commercial banks in Malaysia and die second phase
saw ten more financial institutions joining the scheme.
At the end of 1993, the Islamic banking system in Malaysia
comprised 1 Islamic bank, 20 conventional financial institutions
made up of 10 commercial banks, 8 finance companies and
2 merchant banks which offer services and products based on
Islamic principles. In addition, on 3 January 1994, the Islamic
inter-bank market was introduced. This market consists of the
following three aspects:

(i) Inter-bank trading in Islamic financial instruments.

(ii) Islamic inter-bank investment.

(iii) Islamic inter-bank cheque clearing system.

In line with the intention to further strengthen the development

of the Islamic banking system in Malaysia, the Central Bank of
Malaysia established the National Shariah Advisor}' Council on
Islamic Banking and Takaful (NSAC) on 1 May 1997. The NSAC
comprises ten members, including one international member.
Various decisions were made by this council including allowing
compensations to be incurred on borrowers who fail to repay
financing, allowing women lawyers and non-Muslim lawyers Io
be witnesses to financial documents, and allowing for a second
guarantee. Use of the term "interest-free banking" was changed
to "Islamic banking", and participating banks were required to
promote the status of the departments concerned which should be
headed by someone of a senior position. On 1 October 1999, the
status of monopoly enjoyed by BIMB ended when the government
consented to the establishment of a second Islamic bank. Bank
Muamalat Malaysia Berhad. This second full-fledged Islamic bank
 HISTORY AND DEVELOPMENT Of THE ISLAMIC BANKING SYSTEM 77

was established as a result of a merger between Bank Bumiputra

Malaysia Berhad and Bank of Commerce (M) Berhad. Under the
merger arrangement, the Islamic banking assets of Bank Bumiputra,
Bank of Commerce and BBMB Kewangan Berhad were transferred
to Bank Muamalat Malaysia Berhad. This second Islamic bank
began operations with 40 branches and 1,000 staff.
The commitment of the Malaysian government in promoting
the Islamic banking system could be seen from its on-going plans
to this end. As stated in the Financial Sector Master Plan 2001-2010,
by 2010 the Islamic banking industry and takaful will have the
following features (Bank Negara Malaysia, 2001, p. 79):

(i) Constitute 20% of the banking and insurance market share

with an effective contribution to the financial sector of the
Malaysian economy.

(ii) Represented by a number of strong and highly capitalized

Islamic banking institutions and takaful operators offering
a comprehensive and complete range of Islamic financial
products and services.

(iii) Underpinned by a comprehensive and conducive Syariah and

regulatory framework.

(iv) Supported by a dedicated institution (Syariah commercial

court) in the judiciary system that addresses legal issues
related to Islamic banking and takaful.

(v) Supported by a sufficient number of well-trained, high

calibre individuals and management teams with the required
expertise.

(vi) Epitomize Malaysia as a regional Islamic financial centre.

Tan Sri Nor Mohd. Yakop, the second Finance Minister, during
the officiating of the Non-Islamic Financial Institutions Seminar
organized by Islamic Institutions of Banking and Finance Malaysia
78 CHATTER 2

on 1 March 2004. stated that the Islamic banking system has

entered the third wave of its development. The first wave was the
introduction of Islamic banking; the second referred to the creation
of an Islamic capital market; and this decade represents the third
wave. The third wave encompasses the development and expansion
of Islamic assets and financial instruments associated with waqf,
trust, micro credit, qard liassan and zakat.
bi line with the aspiration to make Malaysia the centre for
Islamic banking, the Central Bank of Malaysia, Bank Negara
Malaysia, approved the applications of three foreign Islamic
banking institutions to operate in Malaysia. On 27 May 2004,
Kuwait Finance House was granted licence, while Al Rajhi Banking
& Investment Corporation, Saudi Arabia and a consortium made
up of Qatar Islamic Bank, RUSO Investment Bank Inc. and Global
Investment House were granted their respective licences on 14
October 2004. Kuwait Finance House started its operation in
August 2005 while the Al Rajhi Bank opened its first branch in
Kuala Lumpur in October 2006. At present the bank has some 19
branches throughout the country. In January 2007, Asian Finance
Bank commenced operation as the third foreign Islamic bank in
Malaysia. The Asian Finance Bank is backed by a consortium of
shareholders comprising Qatar Islamic Bank and associates (70%),
RUSD Investment Bank Inc. of Saudi Arabia (20%) and Financial
Assets Bahrain W.L.L. (10%) (www.asianfinancebank.com).
Concurrent with the progressive liberalization of the Islamic
banking industry and the recommendations made under the
Financial Sector Master Plan to further strengthen the institutional
structure of the banking institutions participating in the Islamic
banking system. Bank Negara Malaysia approved the Islamic
subsidiary structure to replace the Islamic window institutional
structure in 2005. Hence, the seven domestic banking groups
were allowed to transform their current Islamic window into an
Islamic subsidiary within their respective banking groups. But
this transformation was not made mandatory. Under this new
 HISTORY AND DEVELOPMENT OF Till ISLAMIC BANKING SYSTEM 79

structure, Islamic banking subsidiaries are now governed under the

Islamic Banking Act 1983 instead of the Banking Financial Institutions
Act 1992. The new structure eliminated most of the obstacles that
had impeded Islamic windows in participating in non-traditional
banking businesses such as wholesale and retail trading; purchase
of assets and landed properties; and the purchase of equities via
joint-venture and portfolio investments.
The Islamic financial landscape in Malaysia was again
transformed in 2006 with the launching of the Malaysia International
Islamic Financial Centre (MIFC) in August of that year. The MIFC
is the collective efforts of Bank Negara Malaysia, the Securities
Commission of Malaysia, Labuan Offshore Financial Services
Authority' and Bursa Malaysia. It involves the participation of
industry players representing the banking, takaful and capital
market in Malaysia. The main objective of MIFC is to promote
Malaysia as the major hub for international Islamic finance through
several incentives designed to create a conducive environment
for conducting Islamic finance business in Malaysia. As part of its
initiatives, domestic and international banks operating in Malaysia
may conduct Islamic banking business in foreign currencies through
the International Currency Business Units (ICBU) within the
institutions. Foreign participation in Islamic subsidiaries was also
raised to a ceiling of 49% of total equity, which was later relaxed in
2007 by allowing full foreign equity ownership for Islamic financial
institutions established under the MIFC. The MIFC initiatives
also allow domestic and financial institutions to conduct a wide
range of business in international Islamic banking and takaful in
international currency by establishing the International Islamic
Banks (IBB). The IBB which also falls under the purview of the
Islamic Banking Act 1983 can either be a branch or subsidiary of the
parent financial institution. They are accorded the same incentives
as the ICBU.
Presently, there are a total of 17 Islamic banking institutions
(9 Islamic subsidiaries of the domestic banking groups, 2 domestic
80 chaftbr2

Islamic banks, 6 foreign Islamic banks), 2 International Islamic

Banks and 16 Islamic banking operations conducted through
windows by commercial banks, investment banks and development
financial institutions. As at end of 2008, the Islamic banking assets
accounted for 17.4% of the total banking assets of the Malaysian
financial system (Bank Negara Malaysia, 2008). Total deposits in
the Islamic banking system at the end of 2007 accounted for 11.9%
of the total deposits in the domestic banking sector. Meanwhile, the
financing issued by the Islamic banking system as at end of 2007
was 13.7% of the total loans issued in the Malaysian banking sector
(James, 21X19).

History of Islamic Banking System in Iran

As with Pakistan, Iran has also converted its entire financial system
to Islamic banking system. The history of the Iranian Islamic
banking system began immediately after the Islamic revolution in
the country in 1979. The first step taken by the new regime was
to take over all commercial banks in Iran. According to Mehdi
Barzagan, Prime Minister of Iran at the time, the take-over process
was inevitable due to the banks not making profit and the presence of
unhealthy elements. It had to be done to protect tire country's rights
and wealth, and to set the country's economy in motion (Aryan,
1990). As a result of the take-over and reorganization of the banks,
the banking system was represented by only 6 commercial banks
(there were originally 30) and 3 specialized banks. In addition, the
government established 22 provincial banks, one for each province
(Hedayati, 1993).
The Islamic banking system in Iran was implemented on
a gradual basis. It took six years for the system to be fully
implemented. Several factors had caused delay in the
implementation, such as the process of nationalizing the banking
system, the unpredictable political situation, the freezing of
 HISTORY ANO nfVLLOTMENT Of Till! ISLAMIC BANKING SYSTEM 81

Iran's overseas assets, depression, and war. The first step taken
towards the establishment of an Islamic banking system was the
introduction of a service charge into the banking system to replace
the riba system in 1981. Through thjs system, banks imposed a 4%
service charge on loans issued. For deposits, on the other hand,
depositors were given a "guaranteed minimum profit". At the same
time, a comprehensive legislation to Islamize the operations of the
entire banking system was prepared by a committee comprising
bankers, academicians, businessmen and ulania. Eventually in
March 1982, the committee submitted the proposed legislation to
the Revolutionary Council. The law was passed in August 1983 as
the Law for Usury-Free Banking.
The Law required banks in Iran to fully convert their operations
in accordance with Syariah principles within three years and convert
their outstanding interest-based deposits to interest-free deposits
within one year from the date the Law was passed (Aryan, 1990).
With effect 21 March 1984, depositors are not allowed to place their
money into riba-based accounts while banks are not allowed to
provide interest-based credit facilities. From March 1985, the entire
banking system in Iran had been fully converted into an Islamic
banking system. Meanwhile. Bank Markazi (Central Bank of Iran)
is the sole authority in monitoring and supervising the entire*
Islamic banking system in Iran. However, interest is still allowed
in all international trading transactions. Foreign banks were at
first allowed to operate in free trade zones. But starting from 2004,
foreign banks are permitted to open branches throughout Iran
provided that the loans offered are based on the profit-loss sharing
principle (Tehran Times, 1 May 2004). In 2007, three foreign banks
received permits to conduct banking activities in Iran whereas six
more foreign banks are reported to have opened branches in the
country (Tehran Tinies, 29 April 2008). As at end of 2008, there were
seven commercial banks, four specialized banks, six private banks
and one near-bank (www.cbi.ir).
82 CHAPTER 2

History of Islamic Banking System in Pakistan

The history of Islamic banking system in Pakistan started
immediately after the coup d'etat executed by General Zia-ul-Haq
ended in July 1977. On 29 September 1977, General Zia appointed
the Council of Islamic Ideology (CI1) to study and prepare a report
on the elimination of riba in the country's economic system. In
November 1977, CII appointed 15 experts in banking to assist the
council in the preparation of the report. Subsequently in February
1980 this panel of experts submitted to CII the report titled "Report
on the Elimination of Interest from the Economy". After making
certain amendments to the report, the final report was then
submitted by CII to General Zia in June 1980.
The report presented by the council was very comprehensive
and covered specific topics. Among the topics covered include
issues, problems and strategies that would be used in the process
of elimination of the interest system in economy, necessary steps
in the implementation of Islamic banking system, matters related
to the operation of commercial banks, which cover aspects of
financing and receiving deposits, and operations associated
with specific financial institutions such as Pakistan Industrial
Credit and Investment Corporation. Industrial Development
Bank of Pakistan, National Development Finance Corporation,
Agricultural Development Bank of Pakistan, Small Business
Finance Corporation. Equity Participation Fund and insurance
companies. In addition, this council listed in its report the
responsibilities and functions of the State Bank of Pakistan (the
central bank) in controlling and formulating financial policies
based on the Islamic banking system that was to be introduced.
Apart from CII, there were groups formed by other agencies to
study the process of elimination of riba from the country's economic
system. For instance, the Finance Minister of Pakistan appointed a
committee known as the Committee on Islamization to conduct one
such study. A report, titled "Agenda on Islamic Economic Reform",
 H1STOKV ANO DfVlLOI'MI N I Of THl ISLAMIC BANKING S»SIIM 83

was submitted by the committee to the Minister of Finance in April

1980. The State Bank of Pakistan also formed six working groups
to examine and make recommendations for the elimination of riba
from the various sectors in the ecopomv. This group submitted its
report in November 1979. Similarly, the Pakistan Banking Council
formed a Superior Task Force with the responsibility to formulate
the necessary regulations and procedures for the implementation of
the Islamic banking system. The Task Force submitted their report
on 4 August 1980.
Even though there were various groups that conducted studies
and prepared reports on ways to eliminate the riba system in
Pakistan, a number of financial institutions in Pakistan were in fact
alreadv offering services based on Syariah principles before the
reports were presented. In July 1979, three financial institutions,
namely. House Building Finance Corporation, National Investment
Trust and Investment Corporation of Pakistan had converted their
entire operations to Synriu/i-compliant ones. Another financial
institution. Bankers Equity Limited, which began its operations in
October 1979, also practised Syariah principles in all its operations.
As in Iran, the Islamic banking system in Pakistan was
implemented in phases. The phases involved are as follows:

(i) The first phase began on 1 January 1981 when all banks in
Pakistan accepted deposits in the form of profit-sharing
deposits.

(ii) In the same year, the government announced the Mudharabah

Companies and Mudharabah Rules 1981. Commercial banks
were allowed to use money deposited for the purpose of
transactions as listed by the State Bank of Pakistan. However,
where methods of investment were concerned, banks were still
free to choose between Syaruili-based or nlw-based methods.

(iii) On 14 June 1984, the Finance Minister, in his budget speech,

announced that all interest-based transactions, whether new
or existing, were to cease in six months.
M CHATTliX 2

(iv) Beginning January 1985, all financial transactions involving

government and government agencies were conducted based
on Syariali principles.

<v) In April 1985, the same ruling was imposed on all individual
entities and companies.

(vi) From 15 July 1985, all deposits placed with the financial
institutions became interest-free.

Although in principal all deposits and financing received and given

out by commercial banks in Pakistan were free from all elements of
interest, deposits and financing in foreign currencies continued to
be based on interest rates. In November 1991, the Federal Shariat
Court ruled that all procedures practised by banks in Pakistan did
not conform to Islamic principles. The government and financial
institutions appealed to the Shariat Appellate Bench of the Supreme
Court of Pakistan. On 29 December 1999, the Shariat Appellate
Bench rejected the appeal and ordered that all laws involving
interest be revoked.
In line with the Court's decision, the government set up a
number of committees and task force to consider the best wav to
implement the decision by the Court. It was eventually decided
that the transformation of the financial system as a whole was
not possible within a short period of time Instead, the Malaysian
concept whereby the Islamic banking system exists side-by-side
with the conventional system was adopted. In relation to this,
tire State Bank of Pakistan took several measures, including the
formulation of policies to promote Islamic banking on a more
gradual basis. In December 2001, detailed criteria for setting
up Islamic banks were issued bv the Central Bank of Pakistan.
Pursuant to this, Al-Meezan Bank l imited applied to convert into
an Islamic bank. The bank received its license in January 2002 and
commenced operations in March of the same year. It became the
first full-fledged Islamic bank in the country operating under the
 HISTORY ANO DEVELOrMINT Of THE ISLAMIC BANKINC SYSTEM 85

name Meezan Bank. Three existing banks, Muslim Commercial Bank,

Bank Alfalah and Bank of Kashmir were allowed to set up 7 branches
whose operations were based on the Islamic principles. Habib Bank
Limited was also allowed to open a Syariah branch. In 2004, the State
Bank of Pakistan received applications from commercial banks to
set up 24 Syariah branches (Husain, 2004).
In order to allow commercial banks in Pakistan to open Islamic
banking subsidiaries, amendment to the Banking Companies
Ordinance (BCO) 1962 was made under Section 23 of the BCO in
November 2002. The following year, the Central Bank of Pakistan
developed guidelines for the establishment of full-fledged Islamic
banks, Islamic banking subsidiaries as well as guidelines for the
establishment of stand-alone Islamic banking branches in Pakistan.
The guidelines were issued vide BPD Circular No. 1 dated January
2003. A circular on the minimum Syariah regulatory standards
for Islamic banks, Islamic banking subsidiaries and Islamic
banking branches, 1BD Circular No. 2 dated April 2004, was issued
(Islamic Banking Department, 2008). In 2003, the Islamic Banking
Department was established by the Central Bank and is responsible
for all matters related to Islamic banking. The same year saw the
creation of the Syariah Council comprising two Syariah experts and
three experts on banking, accounting and law.
As at the end of 2007, total deposits and total assets of Islamic
banks were Rsl47 billion and Rs206 billion, respectively (Pakistan's
official currency is the Rupee). Currently, there are 6 full-fledged
Islamic banks and 506 Islamic branches of 12 conventional banks
operating in Pakistan. Under the strategic planning for Islamic
banking industry as set out bv the Central Bank of Pakistan
following the re-launch of Islamic banking in the country in 2002,
the industry is expected to capture 12% share of the total banking
industry by the year 2012. At end of June 2008, the market share of
deposits and market share of assets of the Islamic banking industry
stood at 4.5% and 4.2%, respectively of the total banking industry
(www.sbp.org.spk).
86 CHAPTER 2

SUMMARY

The history of modem Islamic banking started with the

establishment of Mit Ghamr Savings Bank in Egypt in 1963.
However, the history of Islamic banking activities can be traced back
to the early days of Islam. Banking activities such as deposit taking,
travellers cheques issuance, money order and money exchange
services, had existed during the time of the Prophet (p.b.u.h.) and
his Companions. Unfortunately, the activities were not developed
and there was no effort to establish a special organization that
consolidated all these activities. The first organization whose
activity was related to the collection and distribution of money was
the Baitulmal. However, the concept and goal of this institution did
not include provision of services to the public in terms of deposits
or financing.
The rise of Europe in the 12th century saw the emergence
of the conventional banking system. The system eventually
spread to Muslim countries. As Muslim countries began to adopt
conventional banking, Islamic banking activities ceased to exist.
As a result, the Islamic banking system which was introduced
during the early years of Islam failed to expand When Islam
was revived in the late 1800s and early 1900s, the practice of riba
among Muslims became the focal point of discussions among
Muslims. Discussions and feelings of uneasiness among the ulama
and Muslim intellectuals continued up until the establishment of
Islamic banking institutions during the modern era. Economist
Dr. Ahmed al-Naggar took the brave step of pioneering a rilxi-free
system by setting up Mit Ghamr Savings Bank in Egypt and proved
that an Islamic banking system could in fact be a substitute for the
practice of riba by conventional banks.
Mit Ghamr’s first modem experiment with Islamic banking
inspired other Muslim countries Io set up their own Islamic banks,
which eventually led to the establishment of a number of Islamic
banks in Muslim countries. I lowever, the development of Islamic
 HISTORY ANO OF.VI lOl'MI N I Of HIE ISl.VMIt BANkINE. SYSTEM 87

banks differed from one country to another. Iran, Pakistan and

Sudan chose to Islamized their entire banking systems, while
in other countries, Islamic banking operates side-by-side with
conventional banking. The contributions of certain bodies such as
the Islamic Development Bank and International Association of
Islamic Banks also boosted the development of Islamic banking in
the world.
Up until the end of 2008, there were more than 300 Islamic
banks operating in both the Muslim and Western countries.
Western conventional banks have also started offering products and
sendees based on Syariah. Apart from Islamic banks, there are also
fund management companies which implement riba-free activities
and these companies are reported to be managing more than
US$800 billion of Islamic funds. Other financial activities such as
insurance and mortgage are now also managed in accordance with
Syariah principles. In addition, the financial market has begun to
use financial instruments based on Syariah. In some countries, such
as Malaysia, an Islamic financial market has also been established
to complement the Islamic banking system. The Islamic banking
system has a bright prospect ahead. Even if it is not used as a
substitute for the conventional banking system, the Islamic banking
system can at least move ahead in parallel with the conventional
system in meeting global banking needs.

REFERENCES AND FURTHER READING

Ahmad, Ziauddin. "Islamic Banking: State of the Art." Jeddah

(Saudi Arabia): Islamic Development Bank, 1994.

Ahmed, Osman. "The Role of the Faisal Islamic Bank." In Islamic

Financial Markets, edited by Rodney Wilson, 76-99. London and
New York: Routledge, 1990.
88 CHATTER 2

Ali, Muazzam. "A Framework of Islamic Banking." In Directory of

Islamic Financial Institutions, edited by John R. Presley, 3-13.
London: Croom Helm, 1988.

Aryan, Hossein. "Iran: the Impact of Islamization on the Financial

System." In Islamic Financial Markets, edited by Rodney Wilson,
155-170. London and New York: Routledge, 1990.

Baldwin, David. "Turkey: Islamic Banking in a Secularist Context."

In Islamic Financial Markets, edited by Rodney Wilson, 33-58.
London and New York: Routledge, 1990.

Bank Islam Malaysia Berhad. Bunk Islam, Penubuhan dan Operasi.

2nd ed. Kuala Lumpur. 1989.

Bank Negara Malaysia. Money and Banking in Malaysia. Kuala

Lumpur: Economic Department BNM, 1994.

Bank Negara Malaysia. Financial Sector Master Plan. Kuala Lumpur,

2001.

Bank Negara Malaysia. Financial Stability and Payment Systems

Report. Kuala Lumpur. 2008.

Central Bank of Sudan. Annual Report 2007.

Connors, Jane. "Towards a System of Islamic Finance in Malaysia."

In Islamic Law and Finance, edited by Chihli Mallat, 57-67.
London: Graham & Trotman, 1988.

De Beider, Richard T. and Mansor Hassan Khan. "The Changing

Face of Islamic Banking." International Financial Law Review.
Vol. 12, Iss. II (Nov. 1993): 23-26.

F.l-Ashker, Ahmed. The Islamic Business Enterprise. London (UK):

Croom Helm, 1987,

El-Ashker, Ahmed. "An Evaluation of the Major Islamic Banks."

In Islamic Financial Markets, edited by Rodney Wilson. 59-75.
London and New York: Routledge, 1990.
 HISTORY AND DEVELOFMI M OF THI IMAMU BANKING SASII M 89

El-Gamal, Mahmoud Amin. "Overview of Islamic Finance."

Occasional Paper No. 4 (August 2006): 1-13.

Erol, Cengiz and Radi El-Bdour. "Attitudes, Behaviour and

Patronage Factors of Bank Customers Towards Islamic Banks."
International journal of Bank Marketing. Vol. 7, No. 6 (1989):
31-39.

Gieraths, Christine. "Pakistan: Main Participants and Final Financial

Products of the Islamization Process." In Islamic Financial
Markets, edited by Rodney Wilson, 171-195. London and
New York: Routledge, 1990.

Haron, Sudin and Bala Shanmugam. Islamic Banking System -

Concepts and Applications. Selangor Darul Ehsan (Malaysia):
Pelanduk Publications, 1997.

Hedayati, Seyed A.A. "Islamic Banking, as Experienced in the

Islamic Republic of Iran." Working paper presented at the
International Seminar of Islamic Banks, Sydney (Australia),
9-10 November 1993.

Homoud, Sami Hassan. Islamic Banking. London (UK): Arabian

Information Ltd., 1985.

Husain. Ishrat. "Evolution of Islamic Banking." Speech given

during the opening ceremony of the seminar on Islamic Banking
organized by Meezan Bank. Pakistan, February 2004.

Islamic Banking Department, State Bank of Pakistan. "Pakistan's

Islamic Banking Sector Review." http://www.sbp.org.pk/ibd/
Islamic-Banking-Review-03-07.pdf

Islamic Development Bank. Annual Report (various issues). Jeddah

(Saudi Arabia).

James, S. "Good Prospects for Islamic Banking." Malaysian Business.

Find Articles.com.http://findarticles.eom/p/articles/mi_qn6207/
is_200080301/ai_n24977546
90 C1UTTU 2

Khan, Muhammad M. The Translation of the Meanings of Sahil

Al-Bukhari, Vol. 3. Lahore (Pakistan): Kazi Publications, 1989.

Mannan, Muhammad Abdul. Islamic Economics: Theory and Practice.

Cambridge (UK): Hodder and Stoughton, 1986.

Mohamad Rajab, Dalal. "Naivasha Peace Agreement Analysis and

Evaluation Part 1." Sudanese Journal for Human Rights' Culture
and Issues of Cultural Diversity. Iss. 2 (March 2006): 1-31.

Rudnick, David. "Islamic Banking: Praying for Profit." Euromoney

(Nov. 1992): 23-25.

Shaban, Mohamed Abu. "The MCCU Story." www.mcca.com.au/

mcca_the_mccu_story.pd f

Siddique, Muhammad. Islamic Banking System: Principles and

Practices. Islamabad (Pakistan): Research Associates, 1985.

Sumner, William Graham (ed.). A History of Banking in All the

Leading Nations. Vol. II. New York (USA): Augustus M.
Kelly-Publishers, 1971.

Syedain, Hashi. "Counting the Quran." Management Today

(Mar. 1989): 104-108.

Tehran Times. "Iran Approves Foreign Bank Branches."

I May 2(XM.

Tehran Times, "b Foreign Banks to Open Branches in Iran."

29 April 2008.

Wheeler, Skye. "South Sudan Orders Islamic Banks to Leave."

http://www.reuters.com

Wilson, Rodney. Banking and Finance in the Arab Middle East.

London (UK): MacMillan. 1983.

Wilson, Rodney (ed.). Islamic Financial Markets. London and

New York: Routledge, 1990.
 HISTORY AND nrVHOl’MI.NT Of I HI ISI A.Mll HANKING SYST1 M Ml

www.asianfinancebank.com

www.banking-business-review.com

www.byeqm.gov.tr

www.cbi.ir

www.imf.org

www.islamicbank.com.ph

www.Lariba.com

www.mcca.com.au

www.sbp.org.spk

www.sukuk.net

www.theubeg.com
 CHAPTER

OBJECTIVES, PHILOSOPHY
AND PRINCIPLES OF ISLAMIC
BANKING

This chapter describes the objectives and philosophy of business that

an Islamic business entity should conform Io. In addition, there will be
a discussion on the Syariah principles which underlie the operations of
Islamic banks the world over. This is so that the reader can have an idea
of the line of thought and essence of conviction of those who lead and
manage Islamic banks. This chapter also explains how funding resources
are obtained and how these resources are used by Islamic banks. Finally, it
will describe in detail thefundamentals on which the relationship between
the Islamic bank and its customer are secured.

INTRODUCTION

When the governments of Iran, Pakistan and Sudan opted to

"Islamize" their entire economic systems, the transformation of the

93
94 CIIATITK 3

economy to a new order raised several theoretical and conceptual

considerations, in particular what type of new economic system
to implement. At that time, only three forms of systems existed,
namely the socialist, socio-capitalist and capitalist systems. The
absence of an appropriate model prompted the three countries to
choose the banking sector as the starting point for their Islamization
process. The Islamization of the economy involved one principal
point, that is, the elimination of interest in all deposits and financing
transactions. Many have questioned the appropriateness of a bank
to be called an Islamic bank for the mere fact that its transactions
do not involve interest although they appear similar to those of a
conventional bank. It is obvious that the establishment of Islamic
banks in most Muslim countries is to cater to the banking needs of
Muslims, and the businesses of these Islamic banks run alongside
conventional banks. Since the goal of the establishment of Islamic
banks is to meet the banking needs of Muslims, the functions and
activities of both Islamic and conventional banks display several
similarities.
Basically, the conventional bank performs two primary functions,
namely, to accept savings deposits and to lend money. Customers
are usually classed into four categories: individuals, businesses, the
public sector and other groups. As a place for depositing money,
conventional commercial banks normally provide four types of
deposit facilities, namely savings account, current account, fixed
deposit and negotiable savings certificate. The type of services may
vary depending on the type of customers as mentioned earlier.
Conventional commercial banks normally offer loans to individuals,
businesses, governments and their agencies, and other groups such
as cooperatives and organizations, Facilities provided are also of
various kinds, which include overdraft, letters of credit, letters of
guarantee and others. In addition, conventional banks provide
additional services like money order transactions, money exchange
and advisory services. The roles played by the commercial banks
may change, subject to situation and time. Currently, commercial
 obiectives, rmiosorin and I'Hin< iri rs or isi amic banking MS

banks have started to offer services which in the past were offered
only by certain financial institutions. Similarly, other financial
institutions have also begun to offer services which in the past were
only available through commercial Vanks.
Just like conventional banks, Islamic banks offer deposits
as well as financing facilities. As a place for depositing money,
Islamic banks offer services almost similar to those of commercial
banks,, such as savings account, current account and fixed deposit.
Islamic banks also offer financing facilities to their customers,
comprising individuals, businesses, governments and other groups
needing financial aid. Other services offered include money order
transactions, money exchange and advisory services. All activities,
however, do not involve the element of riba or interest.
Although the functions and activities of Islamic banks and
conventional banks appear to be identical, this does not imply that
they are based on the same conceptual and theoretical grounds.
Both Islamic and conventional banks differ in terms of their basis for
establishment. Differences exist due to thedifference in the platforms
used for their establishment. Islamic banks are organizations which
are established to administer banking activities based on religious
doctrines. Conventional banks, on the other hand, are established
solely for business purposes and do not involve any religious
aspect.

OBJECTIVES OF ESTABLISHMENT AND

BUSINESS PHILOSOPHY OF ISLAMIC BANKS

In principle, business institutions place profit maximization as their

prime motive. The amount of profit that an organization sets to
achieve would depend on the philosophy adhered to by the owner
and the management. Economic theories state that the objective of a
96 CHATTER 3

business is profit maximization. This profit-making motive becomes

even more apparent if the organization established is privately
owned; where the owner will work hard to attain high profits since
the profits would be solely his. Similarly with businesses established
on a partnership basis; each business partner would strive hard
for the success of the venture. The same goes for private limited
companies, where the shareholder (owner) acts as the manager.
An organization established as a public limited company
rcquiresadditionalsupportstaffinmanagementandadministration.
I lere, the shareholders may not take part in the management of the
company. Hence, the management are not the shareholders and they
are paid salaries for their work. The appointments and dismissals
of the management are carried out by the shareholders, who are
normally represented by the Board of Directors. This encourages
managers to adopt whatever strategy they deem suitable in order
to generate maximum profit to fulfil shareholders’ aspirations.
Large profits are important in a big business organization for two
main reasons. First, large profits would give the impression that
the organization is being run effectively, and this would enhance
the image of the management. Secondly, shareholders normally
would want high returns from the capital invested. Profits would
be distributed to the shareholders in the form of dividends. Hence,
shareholders will be kept happy if the company succeeds in giving
them high yearly returns. The dividends and capital profits (if
any) are regarded as compensation for the risk undertaken by
the shareholders on making the investment concerned. This fact
becomes the principal reason why the ultimate goal of commercial
banks is the achievement of maximum returns for their shareholders
(Elstone, 1987).
Unlike conventional banks where profit is the sole consideration,
the objectives of Islamic banks are founded on two key factors,
namely the factors of religion and profit. When an organization
is established on the platform of religion, it has to internalize the
 OBJECTIVES, rilllOSOEHT AND ER1NCIEI1:S O» ISLAMIC BANKING 97

teachings of that religion which are related to its establishment

and operations. Since Islamic banks are founded on the religion of
Islam, the banks would have to conform to and comply with Islamic
principles. The teachings of Islam, would mould Islamic banks
into organizations that place more importance on moral elements
as compared to conventional banks. The moral elements exist by
virtue of the factor of iman (faith and belief) and Islamic principles
regarding business. Notwithstanding their moral obligations,
Islamic banks are expected to make a profit from their operations.
This is because as business organizations, Islamic banks need to
make profits in order to continue their operations.
According to Ali (1988), the Islamic financial system cannot be
introduced merely by eliminating the practice of riba; rather, it is
done bv adopting and fusing the Islamic principles of social justice
into its rules, practices, regulations, procedures and instruments
to help realize the maintenance and dispensation of justice, equity
and fairness. The concept of justice should be based on the Quranic
concept of justice. Hence, in its objectives of establishment, the
Islamic bank must consolidate and find a proper equilibrium
between religion which emphasizes taultid (oneness of God) and
moral dimension, and business dimension which places importance
on profit. If the moral factor alone is given importance, there is the
possibility that the bank would experience losses and be forced
to cease operations. If this happens, not only will the depositors
lose their deposits, but it would bring about a loss to Muslims as
a whole.
Similarly, if the profit factor alone is given priority, the bank
would deviate from the actual Islamic platform centred on the
concepts of justice and equality, upon which it is established.
Society would then regard Islamic banks to be no different from
conventional banks. In such circumstances, society would choose to
patronize conventional banks over Islamic banks given their longer
exposure to the conventional system, and that they are deemed to be
more stable and efficient in providing banking services to society.
98 CHATTER 3

Khan (1983) stated that the objective of the Islamic bank is to

develop, foster and promote the use of Islamic principles, laws
and traditions in all banking transactions, financial, business and
other related areas. Apart from promoting the "Islamization" of
all banking activities, Islamic banks also have the responsibility
to promote the establishment of investment companies or other
business enterprises so long as these companies are not involved in
activities that are forbidden by Islam The establishment of Islamic
banks is not merely for the attainment of profits. Consequently,
most Islamic banks have set their business goals and objectives by
incorporating moral and social elements. For instance. Bank Islam
Malaysia Berhad in the initial period of its establishment had set its
goal as follows (Bank Islam Malaysia, 1985):

The corporate goal of this bank is to provide banking facilities and

servicesfounded on Islamic principles, regulations and practices to all
ethnicgroups and citizens ofthis country. These principles, regulations
and practices are tn truth Islamic mualamah rules lahkam al-niuamalat
al-lslamiah) related to banking and financial transactions. The bank's
effort to provide these facilities and services are undertaken within the
framework of its viability and capability to continuously grow and
expand.

Due to changes that have occurred in the business demands of today

and the increasingly globalized Islamic banking landscape, Bank
Islam Malaysia has renewed its vision and mission following the
launch of the bank's new corporate identity in August 2007. The bank's
new vision and mission are as follows (www.bankislam.com.my):

Vision:

71’ he the global leader in Islamic banking.

Mission:

(i) To continually develop and innovate accepted financial solutions in

line with Syariah principles.
 osrccnvES, riuiosorm and huncii’ies or isi.amic ranking W

(ii) To provide a reasonable mid sustainable return to shareholders.

(iii) To provide for a conducive u-orking environment and to become an

Employer of Choice for top talents in lite market.

(iv) To deliver comprehensive financial solutions of global standards

using state-of-the-art technology.

(v) To be a responsible and prudent corporate citizen.

A close examination of the bank's new goals and mission will

reveal that emphasis is now placed on it becoming a global player
in Islamic banking products and looking after the interest of its
shareholders.
Bank Muamalat Malaysia Berhad, the second Islamic bank to be
established in Malaysia, currently have the following as its vision
and mission (www.muamalat.com.my):

Vision:

To deliver best value to stakeholders.

Mission:

To become the preferred Islamic financial service provider regionally.

Dubai Islamic Bank, established in 1975, is one of the world's first

Islamic banks. It had in the early part of its establishment aimed to
prevent Muslims from dealing with transactions involving riba as
one of its principal objectives because such practice is forbidden by
Allah (s.w.t.). Hence, Muslims would be protected from falling into
one of the big sins in Islam. Due to changing times, Dubai Islamic
Bank, similar to Bank Islam Malaysia, has amended its vision in
order to better reflect the significant development and growth that
the bank has achieved. It now aspires to be the most advanced
bank in providing innovative banking services according to rules
stipulated by Allah (s.w.t.). Since 1999, Dubai Islamic Bank has set
its vision and mission as follows (Dubai Islamic Bank, 1999):
100 CHATTER 3

Vision:

To be the leading provider of innovative financial services guided by

the teachings of Allah.

Mission:

To be the first Islamic bank worldwide, that has translated true

Islamic economic principles into practice, out offirm belief in the need
of mankind for an economic system based on the Final Revelation.
Bu partnering with our customers in halal earnings, employing the
best business practices, the latest financial services technologies and
placing our trust in Allah, we are confident ofour success.

The bank has also specified its values as follows:

(i) Lifestyle: We believe in a life that conforms to the values and

principles of Islam.

(ii) Clients: We value our clients and their satisfaction is our

priority. Our clients are our close friends and most valuable
asset.

(iii) Accuracy and efficiency: We understand that our clients value

their time. Hence, we strive to provide services which are
accurate, efficient and fast.

(iv) Strong relationship: We seek clients' loyalty and work towards

strengthening their relationship with us.

(v> Innovation: We place importance on the differences in

experience undergone by our clients and constantly perform
innovations and improve our services for them.

(vi) Group cooperation: Group cooperation is essential to what

we undertake. We value and respect all ideas and opinions
which contribute towards the overall enhancement of the
performance of the organization.
 OBJECTIVES, rillLOSOEHT AND EKINCIEIES OF ISLAMIC BANKING 101

(vii) Social: We contribute actively to society by developing

resources and promoting economic growth.

In line with these values, Dubai Islamic Bank has outlined its
goals to cover aspects of quality services, profitability and social
responsibility. Its comprehensive goals are as follows:

• To provide banking services with the highest standard

according to Synriah without involving riba and applying the
latest technology, using computers, telecommunications and
information systems.

• To undertake investments wisely, to obtain optimum returns,

not maximum profit, for the mutual benefit of the bank and its
clients.

• To coordinate, cooperate and act together with other financial

institutions which practise Syariah in their transactions in order
to support efforts to establish a foundation and regulation for
the Islamic financial system.

• To develop the society of Muslims in all areas of economy by

investing in the areas of industry, agriculture, trade and real
estate to create more job opportunities.

• To promote within society the attitude of helping one another

for goodwill through Islamic methods, particularly through
zakat.

• To contribute to the welfare of society in line with the five

essential aspects in Islam: protection of life, authenticity of the
mind, property, honour and social justice.

• To encourage the habit of saving anil wise investment according

to Syariah rules, using financial and investment instruments
suited to individual needs.
102 CHATTER 3

• To provide relevant capital to entrepreneurs to create economic

projects and to make available financing methods which
conform to Syariah.

However, since 2000, the bank no longer reports its values and goals
in its annual report.
One of the largest private commercial banks in Bangladesh,
Islami Bank Bangladesh Limited (IBBL), has also outlined its special
features. These special features revolve around aspects of fulfilling
social responsibility and the aspiration to develop the economy
of Muslims based on Syariah. The poor and the less fortunate are
the target groups of this bank. The goals initially were as follows
(Islami Bank Bangladesh, 1999):

(i) All activities are performed in accordance with methods of the

interest-free system based on Syariah.

(ii) The range of investments undertaken is those permitted by

Syariah.

(iii) Income from investment is shared with depositors under the

mudltarabah principle according to ratios which are regarded
reasonable in terms of the deposits they made.

(iv) To introduce a welfare-oriented banking system and to

establish equity and justice in the field of trade and commerce.

(v) To encourage socio-economic uplift and provide financial

services to the low-income community particularly in the
rural areas.

(vi) To play a vital role in human resource development and

employment generation particularly for the unemployed
youths.

(vii) To achieve balanced growth and equitable development

through diversified investment operations particularly in the
priority sectors and less developed areas of the country.
 objectives, philosophy and rKiNCinr.s of Islamic hanking 103

However, in line with current developments and globalization

demands, Islami Bank Bangladesh later revised its targets and goals
as follows (www.islamibankbd.com):

• To conduct interest-free banking businesses.

• To establish participatory banking instead of banking based on

creditor-debtor relationship.

• To invest on profit-and-risk sharing basis.

• To receive deposits based on mudharabah and wadiah principles.

• To establish a welfare-oriented banking system.

• To extend cooperation to the poor, the helpless and the

low-income group for their economic upliftment.

• To play a significant role in human development and

employment generation.

• To contribute towards the balanced growth and development

of the country through investment operations, particularly in
the less developed areas.

• To contribute in achieving the ultimate goal of the Islamic

economic system.

Meanwhile, Bank Muamalat Indonesia's original vision is as given

below (Bank Muamalat Indonesia, 1998):

To make Bank Muamalat Indonesia a bank that is the pride of

the ummah, that is, one of the best banks in its class. It aims to:

(i) Stay healthy or in good financial condition, and this is to

be measured whether in terms of rules and regulations of
Bank Indonesia or in terms of Syariah.

(ii) Acquire profits.

(iii) Make its shares attractive to society.

104 cuaftck3

(iv) Possess a wide working network with global business

capacity.

(v) Provide a productive place for the advancement of career

for every staff member.

The original mission of Bank Muamalat Indonesia was:

(i) To play a role in the economic development of the Indonesian

race, particularly through efforts to uplift the role of Muslim
entrepreneurs and to act as catalyst to the expansion of the
Syariah Financial Council

(ii) To deliver appropriate profits to shareholders.

(iii) To work towards optimum operational growth.

(iv) To provide positive contribution to the Muslim society.

(v) To maintain and enhance the quality of working life.

The original vision and mission were later revised in 1999 and
applied until 2005. Bank Muamalat Indonesia's new vision is:

(i) To be the principal Syariah bank in Indonesia.

(ii) To be a dominant player in the Syariah market.

(iii) To be a bank that is respected in the rational market.

The mission was revised as follows:

(i) To become a Syariah bank that is managed professionally,

emphasizing excellence in management, market orientedness
and the spirit of entrepreneurship.

(ii) To become a model for the organization of Syariah banks.

(iii) To become the most innovative bank in investment activities.

However, Bank Muamalat Indonesia again made improvements

to its mission in 2006. The change was deemed necessary in the
 OBJECTIVES, PHILOSOPHY AND PRINCIPLES Of ISLAMIC BANKING 105

light of changes in the Islamic banking system in Indonesia.

A number of Syariah banks have been established in Indonesia.
Among them is Bank Perkreditan Rakyat (BPR) which is active
in providing Syariah banking products. This has created strong
competition in Indonesia's Islamic banking system. At the end
of 2008, the Islamic banking system in Indonesia comprised
5 full-fledged Syariah commercial banks, 13 Islamic Banking Units
which are branches of private national banks, 15 Islamic Banking
Units which are branches of regional government banks and
128 Islamic rural credit banks(www.bi.go.id). To meet thechallenges
to the Islamic banking scene where competition is expected to
intensify, Bank Muamalat Indonesia, the leading Islamic bank in
Indonesia up until year-end 2007, has the following new vision and
mission (www.muamalatbank.com):

Vision:

To become the premier Syariah bank in Indonesia, dominant in the

spiritual market, admired in the rational market.

Mission:

To become a role model for Syariah financial institutions the world

over emphasizing on entrepreneurial spirit, managerial excellence, and
innovative investment orientation, to maximise value to stakeholders.

This concept of a balance between profit and social obligations

is also the stand of other Islamic banks in South East Asia. For
example, Al-Amanah Islamic Investment in the Philippines, which
was established on 26 January' 1990 and commenced operations on
11 February 1991, has stated clearly' in its establishment statute that
its corporate mission is (www.islambank.com.ph):

To promote and expedite the socioeconomic development in the

Autonomy Region by implementing banking, finance and investment
operations, and to participate in the areas of agriculture, trade and
industry, using the concepts of the Islamic banking system.
106 cHArrtK 3

The Islamic Bank of Thailand is the only commercial bank in the

country that complies with Syariah. This bank was established in
2002 and its vision is as follows (www.isbt.co.th):

First andforemost, this bank operates businesses based on Islamic rules.

This bank should by right become strong and stable with excellent
sendees under efficient management and good supervision.

Meanwhile, the Islamic Bank of Thailand's mission is:

(i) To maintain the bank’s role of non-involvement in interest

(riba).

(ii) To reinforce the stability of the organization.

(iii) To provide excellent services.

(iv) To provide complete business instructions and supervision.

(v) To implement social and societal development.

Dar al-Maal al-lslamic Trust, an Islamic organization established in

1981 as a holding company for 21 financial and business companies
operating Islamic banking businesses and insurance in four
continents, outlined the following objectives in 1992 for its group
companies (Faysal Islamic Bank of Bahrain, 1992):

(i) To offer to all Muslims, contemporary Islamic financial services

that serve to execute their financial dealings in strict respect of
the ethical, individual and social values of the Syariah without
contravening the heavenly imposed prohibition of dealing
in riba.

(ii) Toserve all Muslim communities in mobilising and utilising the

financial resources needed for their true economic development
and prosperity within the principles of Islamic justice, and
assuring the right and obligations of both the individual and
the community.
 OHUCTIVES, rimnsorin ani> vkim ii'ii s or Islamic bansim. 107

(iii) To serve the "Ummat al-Islam" (Islamic communities) and

other developing nations by strengthening the brotherhood
bonds through mutually beneficial financial relationships
for economic development, and an enhanced environment
for peace.

To be in line with the changing times, Dar al-Maal also changed

its objectives and added values such as the following (Dar al-Maal
al-Islami Trust, 1998):

(i) To create an Islamic banking and financial institution in a

modem and competitive environment,

(ii) To be known as the front-most Group among Islamic financial

institutes, providing services and products of quality and high
standards.

(iii) To increase the income capacity of the Group and to maintain

continuous value-added benefits for equity participants,
investors and workers.

(iv) To contribute to economic development in countries where the

Group is based, has investments or has business partners.

(v) To play a principal role in enhancing cooperation among

financial institutes.

(vi) To develop good relationships with conventional financial

institutes.

The values of Dar al-Maal are:

(i) ToabidebylslamicSynrifl/i principles which form the legislation

for the business being implemented.

(ii) To persevere to obtain halal profits and sturdy development,

and to increase efficiency.

(iii) To work as a group to protect the interest of the organization.

108 chai"ti:k3

(iv) To focus attention on the services provided to participants and

clients, and to foster relationships based on trust, unity and
mutual benefit.

Since the year 2000, however, Dar al-Maal no longer displays the
group's goals and values in its annual reports.
Besides Dar al-Maal. another giant company which is involved
in the Islamic financial sector is Dallah Albaraka. This group was
founded in 1969 and has interests in 300 companies in 44 countries.
The total assets of Dallah Albaraka exceed US$7 billion In the
finance industry, this group has interests in 23 Syarioh-based banks
and financial institutions. The goal and philosophy held by its
banking institutions at group level are as follows (www.albaraka.
com):

Vision:

To serve the communities where toe live and operate, through

responsible social and environmental activities. To meet the long term
interest of our clients, providing them with quality products and
services. For prospectin' shareholders, a high return on investment
through the selection and implementation of products 'which are
low risk, detailed, and diverse with high future potential. We are
committed to providing a professional, creative work environment,
for our employees, characterized hy transparency, openness,
accountability and respect for all.

Mission:

As a multi-purpose investment group: we seek to provide quality

Sharia compliant investments and financial services. We will continue
to improve and develop the diverse range of our business products
- specifically in the areas of recreation, health, environment, food
production, and real estate throughout the Middle East and the rest
of the world. We are dedicated to providing high standards of ethics
and integrity in everything we do.
 objectives, miLosorm and rKiNciri.ES or Islamic banking 109

The goal and philosophy of Dallah Albaraka are the tenets of all of
its companies up to the level of the subsidiary companies and this
can be seen through the vision and mission statement of one of the
subsidiary companies, Albaraka Islamic Bank. Bahrain. It reads as
follows (www.barakaonline.com):

Vision:

To be n leading and diversified international Islamic bank, offering

a wide range of quality products and services and forming strategic
alliancesfor a competitive edge.

Mission:

We strive to be a premier regional Islamic bank, dedicated Io the

economic and social development ofour target markets, maximizing our
clients' and shareholders' value. and focusing on the human resources
development in an environment of creativity and innovation.

On examination of all the goals and objectives of Islamic banks, it

can be concluded that the majority of Islamic banks place emphasis
on fulfilling social responsibility. This is what distinguishes
Islamic banks from conventional ones. However, even though
conventional banks have no religious obligation to fulfil, this
does not stop them from performing their social responsibility.
In fact, there are instances when conventional banks give greater
prominence to social programmes. These programmes encompass
aspects of education, lightening the burden of the disabled and
raising the standard of living of the poor. By right, Muslims should
feel slighted if Islamic banks were to place importance on profit
maximization while neglecting their social responsibility. But then
they also do not wish for Islamic banks to be overly concerned
with social responsibility as to disregard aspects of efficiency and
profitability.
110 CHAPTER 3

SOCIAL PRACTICES OF THE WORLD'S

ISLAMIC BANKS

The majority of Islamic banks worldwide are sensitive to social

responsibility, and this is in line with the goal of their establishment
as institutions with moral and profit-making motives. Whether or
not an Islamic bank performs its responsibility or plays its role in
enhancing the socio-economic welfare of Muslims can be seen from
the social activities conducted. Some banks do not clearly state their
social responsibility, yet many of their activities are in fact moving
in that direction. Also, there are some which do not mention in
detail the social activities conducted.
Among the Islamic banks renowned for their social activities
are Jordan Islamic Bank, Islami Bank Bangladesh and Social
Investment Bank. In Malaysia, Bank Muamalat Malaysia is also
active in fulfilling its social responsibility.
Jordan Islamic Bank (JIB) has been involved in the supply and
installation of equipment in educational institutions in Jordan
since its establishment. Every year, this bank allocates a part of its
profits for the use of universities, scientific research and vocational
training. At the end of the 21X17 financial year, for example, as much
as JD189.320 was given out to universities in Jordan, and the same
amount was allotted to finance vocational and scientific training
(Jordan's official currency is Jordanian Dinar or JOD). Apart from
this, JIB also makes contributions and donations to mosques, zakat
organizations and associations. An amount of JD201.500 was used
for this purpose in the 2007 financial year. In addition, financing
structured along the Syariah principles of yard hassan, musyarakah
and ntudharabah, was awarded to individuals facing financial
difficulties. Financing was also allocated to youths who wished to
be married, and to handicraft makers. By the end of 2(X)7, a total of
71 projects under the craftsmen programme were financed by the
bank. The total balance for the said programme was JD1.6 million
at the end of 2007 (Jordan Islamic Bank, 2007).
 objectives, ruiLosorm ani> miNCirus or Islamic banking 111

Islami Bank Bangladesh conducts various social activities

through a specially created body. Tire Islamic Bank Foundation. By
the end of 1998, this Foundation had built two modem hospitals,
service centres, sales centres and started several Bangladesh
socio-economic development projects. The Foundation also
established two types of training centres, namely vocational
institutions providing vocational training to unemployed youths,
and colleges that offer religious and moral education. In line
with the objective to increase the level of income of the poor, the
Foundation set up a sales centre where the public can purchase
products produced by the poor and women facing difficulties. In
addition, the Foundation has special funds to help those in difficulty
as a result of floods or other disasters.
Just like Islami Bank Bangladesh, Social Investment Bank,
Bangladesh is highly concerned with its moral responsibility. Not
only does this bank implement this responsibility through its range
of activities, but it also aids the public or its customers in carrying
out activities for the development of ummah in the Muslim world.
This assistance is given through facilities created to activate public
funds which are intended to be channelled for welfare purposes.
Collection of funds is done through two ways, that is, either in the
form of wakaf certificates, whereby the fund contributed will not be
returned to the donor but instead is used for the purpose mentioned,
or in the form of bonds. In the case of funds collected in the form
of bonds, the face value is returned to the owner at the end of the
stipulated period, but the yield obtained through the transaction
will be channelled to goodwill activities as chosen by the purchaser
of the bond. The following are among the financial instruments
created for this type of funds for socially useful purposes such as
welfare or goodwill (www.siblbd.com):

• Development Bonds of Wakaf Property (general and specific).

• Certificate of Wakaf Cash Deposit (general and specific).

• Family Wakaf Certificate.

112 CHATTER 3

• Development Bonds of Mosque Property (general and specific).

• Mosque Community Shares.

• Certificate of Qard Hassan (general and specific).

• Certificate of Payment of Zakat and Taxes.

• Certificate of Hajj Savings.

• Development Bonds of Non-Muslim Trust Properties (general

and specific).

• Development Bonds of Local Council Property (general and

specific).

In addition to consolidating funds for goodwill purposes, Social

Investment Bank has established a savings fund known as the
Social Fund. The money channelled to this fund comes from the
business profits obtained by the bank. Public contributions in the
form of donations, alms and zakat are also channelled into this
savings fund. The funds collected are used for the poor and needy,
as well as for educational support in the form ot scholarships and
health financing.
Bank Muamalat Indonesia (BMI) has also not neglected its
functions as an organization that grants positive contributions
to the Muslim society in Indonesia. The following are among the
activities on its social agenda:

(i) To develop small businesses.

(ii) To create economic development projects for the society.

(iii) To create a savings fund for the collection of zakat and alms
from the public

(iv) To distribute the funds of the International Development

Foundation,

(v) To establish a financial institution retirement fund.

 obif.ctives, PHiLosorm and hunch-les of Islamic banking 113

BM1 has created profit-loss sharing scheme. At the end of 2007,

38.6% of the total amount of financing issued by BM1 was financing
of this form. Through its partner, Baitumaal Muamalat (BMM),
the bank has implemented various corporate social responsibility
programmes including the distribution of Rp9.6 million in 2007
in relief aids to areas that were stricken by natural disasters and
managing a scholarship programme for tsunami orphans from
Acheh on behalf of the Islamic Development Bank. In 2007, a
total of 1,600 scholarships were given out to students under this
programme (Bank Muamalat Indonesia, 2007).
Bank Muamalat Malaysia also has social and society-related
programmes. Apart from issuing zakat, this bank conducts a special
programme called Masih Ada Yang Sayang (There Are Still Those
Who Care). Through this programme, the bank conducts activities
to collect funds for distribution to students who need financial
assistance.
In addition to conducting social activities, Islamic banks have
a role in creating awareness among their customers that Islamic
banks are in fact different from conventional banks. This awareness
is important because without it, customers may perceive there to
be no difference between these two types of banks. Such thinking is
unhealthy, especially when a client's purpose to patronize an Islamic
bank is merely to obtain profits from his savings or investments
and not based on religious factor.
Several researches have shown that there are customers who
perform transactions with Islamic banks solely for profit purposes
(Erol and El-Bdour, 1989; Haron and I’lanisek, 1994). Efforts
to educate society on Islamic banking should be made in an
all-encompassing and integrated way. There should be cooperation
between Islamic banks and educational institutions. Students
should be exposed to knowledge about Islamic banking starting
from school level.
114 chaittr3

FACTORS THAT INFLUENCE THE FORMATION

OF THE PHILOSOPHY OF ISLAMIC BANKS

Factors that influence the formation of the philosophy of an

organization may be divided into two, namely external and internal
factors. External factors are normally beyond the control of the
organization. Examples of external factors are laws of the country in
which the organization operates, the environment, clients' thoughts
and views, competitors' behaviour, changes in the economy and
changes as a result of acts of the Almighty. Internal factors, on
the other hand, are those that may be shaped or changed by the
organization itself.
When there is intention to establish an Islamic bank, the
philosophy of the bank will be influenced bv external and internal
factors. For exam pie, an Islamic bank that is to be established should
consider social issues, if any of the following situations prevails:

(i) The law requires that a bank allocate part of its profit for
education, research or development of the umrnali.

(ii) The law requires that a bank provide some funding for loans
in the form of qard hassan, or channel aids to the needy or the
low-income groups.

(iii) There are many competitors conducting social programmes

Hence, the bank must also conduct similar activities to
demonstrate its social responsibilities.

(iv) File bank exists in the midst of a caring communitv. Hence, its
social programmes would always obtain the full support of its
customers. For instance, if a fund for social causes is launched,
customers would give their full support.

Internal factors play a role in the initial stage of the bank's

establishment. For example, when a group of investors use their
money to set up an Islamic bank, they would normally want high
 OBIECTIVES, PHlIXJSOrilV AND ERlNCII-llS Of ISLAMIC BANKING 115

returns, thus resulting in the practice of profit maximization.

However, in reality, due to the high capital needed to set up the
bank, the owners and managers would often consist of different
types of groups. This implies that the formulation of the bank's
philosophy will be influenced by two main factors, that is, the extent
of the involvement of the owners in influencing the thinking of the
management, and the beliefs and practices of the management itself
in managing the bank.
Under normal circumstances, the management would be
influenced by three conceptions. The first concept is that shareholders
would definitely want high returns on their investment. If this belief
exists, then the management would be working hard towards gaining
profits to deliver to the shareholders with the expectations that they
will be entrusted to continue running the bank. High profits also
indicate excellent performance and effectiveness in management. The
second conception is related to rewards received. If the management
believes that rewards are largely dependent on profits attained, they
would strive to maximize profits. This is based on the notion that
the bigger the profit, the bigger the rewards they would receive in
the form of bonuses and annual increments on their salaries. The
third belief is that depositors must be rewarded with high returns;
otherwise they may switch to other banks. This switching of banks
by depositors would give the bank a bad image. In such situations,
management would again be striving hard to maximize profits in
order to reward high returns to depositors.
Hence, the three key motivators, namely, the desire to attain
high returns to allot to the shareholders for the sake of the future
of their career; the desire to attain high profits in order for them
to obtain maximum salaries, annual bonuses and other forms of
rewards; and the desire to give out high returns to depositors to
prevent them from switching banks; would all influence the bank's
top management to subscribe to the profit maximization philosophy
and disregard the social element and welfare of the ummah. Social
activities such as provision of qani hassan loans, financing for
116 cH.xrrr.K3

small businesses and others, would probably be given the lowest

priority.
Although there are hundreds of Islamic banking institutions in
the world, they may be classed into three categories as follows:

(i) Ordinary financial institutions offering Islamic banking

products and services.

(ii) Islamic financial institutions operating banking businesses.

(iii) Islamic financial institutions offering Islamic banking products

and services.

An Islamic banking institution is classed based on the practices

and philosophy that it proclaims. A financial institution in the first
category merely offers services which are not prohibited in Islam,
but does not adhere to other business principles as required by
Islam. The second category comprises financial institutions which
regard themselves as Islamic financial institutions, but in reality
the products and sendees they offer are similar to those offered by
ordinary financial institutions. The third category is considered the
best in the sense that not only do these financial institutions offer
Islamic banking sen ices, but in fact all their business operations are
founded on Islamic business principles. Views that an Islamic bank
or an Islamic financial institution should place importance solely on
profits are due to conventional banking. Within the context of profit
maximization, it must be reiterated that while profit is important,
in an Islamic paradigm, it must be balanced with the requirement
of social justice.
It follows then that the objective of the establishment of Islamic
banks is a blend of the religious and business dimensions. Hence,
all business activities related to financial transactions and banking
must be conducted in accordance with Islamic principles and laws.
These banks are also forbidden from engaging in business activities
that are prohibited by Islam. Islam encourages its followers to
engage in trade activities as stated in Sura): nl-Baqnrall, verse 275,
 OBJECTIVES, FHlLOSOrilV ANO PRINCIPLES OF ISLAMIC BANKING 117

where Allah (s.w.t.) allows Muslims to do business but forbids riba.

The Prophet (p.b.u.h.) was a trader and businessman in his early
life, and so were most of his Companions. The most important
aspect of Islamic banking is that its, operations must be conducted
without any elements of riba. The act of giving and receiving riba
is forbidden, as stated in both the Quran and Haitilh (a detailed
discussion on riba is found in Chapter 4 of this book).
Siddiqi (1986) believed that riba is considered not only as
detrimental to morals, but also destructive to society and is an
obstruction to the overall development of the ummah. Siddiqi
referred to the view of Iman Razi (543 H/l 149-606 H/1209), a
Muslim scholar who condemned riba because it eroded other
people's property, gave rise to conflicts in society since only a
handful would be rich while the poor would become poorer, and
consequently such a situation would tarnish the reputation of the
creditor. Regardless of the form of business carried out, elements
of uncertainties are bound to exist. Each business executed is not
assured of success and the business may at any time be exposed to
losses. Since the success of the business is uncertain, it is therefore
unfair if the creditor requires the businessman to pay him a fixed
amount and the payment must be made regardless of whether
or not the business makes a profit. In other words, the creditor
would always receive returns from what he has loaned out even
when the businessman faces a loss. The businessman, on the other
hand, would have to make payments even when his business is not
profitable.
Nonetheless, a bank whose operations are free from elements
of riba does not qualify to be a truly Islamic organization because
prohibition of riba is only one of the Islamic principles of business.
Islam has outlined a range of principles for its followers to conform
to when undertaking business. Apart from complying with clear
guidelines on methods of handling a business, Islamic banks must
also adhere to the rules and laws affecting individual Muslims.
When all these rules have been complied with, only then can the
118 CHA1TEK3

bank be regarded as an Islamic organization. Once an Islamic

bank understands the position and the rules that an institution or
organization needs to adhere to, developing its business philosophy
is effortless.
The business philosophy covers a large area and includes
a variety of issues such as beliefs, practices and guidelines that
must be adhered to bv the Islamic bank in its operations. Business
philosophy also includes patterns and forms of relationships
practised by the bank with its depositors, investors and other
parties who require its assistance and services. Further, the business
philosophy must be upheld not only by the policy makers but also
by the implementers. The parties involved normally include the
Board of Directors, managers and staff of the bank. The business
philosophy is sometimes different from the mission of the company
and at times may even differ from the objective that the company
strives to achieve.
Al-Azuhaily (2003) was of the opinion that a financial institution
may be regarded as an Islamic financial institution as follows:

The function ofan Islamic financial institution is to collect funds and

to invest them on behalfof its participants (clients who put in deposits
using the principle of profit-loss sharing). The goal of this institution
is to restore the society of Muslims and to achieve cooperation among
Muslims, al the same time complying with the fundamentals ofIslamic
legislation. This legislation requires that there be no involvement in
riba and other prohibited contracts, besides the distribution of profit
based on ratios which are unbiased, without any injustice. Il also
aims to help those in need through interest-free loans in addition to
supporting the socio-economic growth of the Muslim society.

Al-Azuhaily also highlighted the importance for the Islamic bank

to display its distinctiveness compared to conventional banks.
Besides complying with Islamic rules and laws, Islamic banks
must also be capable of competing with conventional banks as well
 omi ci'ives, riinosorin and i-hincii’i is oi Islamic hanmnc. 119

as have the capability to fulfil the banking and economic needs

of Muslims. Among the main characteristics which differentiate
between Islamic and conventional banks are:

(i) Islamic financial institutions' must comply fully with the

requirements of akidah by not being involved in any transaction
that contains elements of riba and other businesses forbidden
by Islam.

(ii) Islamic financial institutions must be caring and more

understanding when their customers face financial
difficulties.

(iii) Islamic financial institutions should not have profit

maximization as the principal goal; rather, they should have
goals towards socio-economic development and poverty
eradication.

(iv) Islamic financial institutions need to be more transparent in

each of their transactions. In this way, depositors are made
aware of how their money is being used and the returns they
would be receiving. Similarly, transparency in the issuance of
financing would ensure that there would be no elements of
exploitation.

(v) Operations of Islamic financial institutions differ from those

of conventional banks, and these include aspects of deposit
taking and financing.

(vi) Islamic financial institutions must provide services to all

communities in the society regardless of the types of customers
and their status.

(vii) Islamic financial institutions must only impose charges on

customers in accordance with the actual cost incurred in
providing the service concerned.
120 CHArrtn 3

SOURCES OF ISLAMIC BANKING

PHILOSOPHY

Generally, conventional financial institutions do not have a preset

source of reference when drawing up their philosophy. Frequently,
the philosophy created and chosen is developed based on past
experiences and future directions. Management thoughts also
have an influence on the type of philosophy to be upheld by the
organization. However, this problem is not present in Islamic-based
institutions. This is because as a business entity established within
the ambit of Islamic principles, the foundations of the philosophy
of Islamic business are those principles which have been revealed
in the pure and absolute source of Islam, that is, the Quran. Allah
(s.w.t.) in Surah Ali-lmran, verse 132, says:

And obey Allah and the Messenger; that ye may obtain mercy.
(Q3: 132)

In Surah an-Nisaa, verse 59, Allah (s.w.t.) says:

O ye who believe! Obey Allah, and obey the Messenger, and those
charged with authority among you. If ye differ in anything among
yourselves, refer it Io Allah and His Messenger, if ye do believe in
Allah and the Last Day: that is best, and most suitable for final
determination.(Q4: 59)

Further, Allah (s.w.t.) says in Surah al-Maidah, verse 92:

Obey Allah, and obey the Messenger, and beware (of evil): if ye do
turn back, know ye that it is Our Messenger's duty to proclaim (the
Message) in the clearest manner. (Q5:92)

Besides the verses above, other related verses are verses 64 and 80
to 81 Surah an-Nisaa (Q4: <>4. 80-81). verse 12 Surah Ibrahim (Q14: 12),
verses 20 to 25 and verse 46 Surah al-Anfaal (Q8: 20-25 and 46), verses
51 to 52 and verse 54 Surah an-Niir (Q24:51-52 and 54), verse 33 Surah
 OBjECTiVES, rniLosorm and principles or Islamic banking 121

Muhammad (Q47: 33), and verses 11 to 12 Surah at-Taghaabun (Q64:

11-12), Hence, the core philosophy of Islamic banks should be in
line with the revelations in the Quran and Hadith. Revelations and
Hadith which require Muslims to uphold justice and virtue, serve
as guiding principles for Islamic banks in managing their business
affairs. Apart from these two sources, two other Syariah sources are
qiyfls and i/ma. As an institution founded on Islam and mostly led by
Muslims, these are the sources that should be strongly referred to. It
is considered unwise if Islamic banks disregard these Syariah sources
and in their place use Western sources as their guide and reference
when formulating their philosophy and incorporating it into their
corporate objectives and policies.

THE ESSENCE OF THE BUSINESS

PHILOSOPHY OF ISLAMIC BANKS

Islam regards business as an endeavour which requires honesty

and as a source of sustenance for Muslims. The Prophet (p.b.u.h.)
in his early life before he was appointed a Messenger and similar
with many of his Companions, was a businessman. It must be
remembered, though, that Islam advocates the implementation of
business by Muslims according to the principles as stipulated by the
religion. The meaning of righteous trade in Islam is best explained
in Surah Fatir, verse 29, which says:

Those who rehearse the Book of Allah, establish regular prayer, and
pend (in Charity) out of what We have provided for them, secretly and
openly, hopefor commerce that will never fail. (Q35: 29)

The above verse asserts that those who constantly adhere to the
teachings of die Quran, never neglect prayer and give to charity are
those who will succeed in their business. This verse also expresses
that business in terms of charity from the Believers does not come
122 CHATTER 3

from uncertain sources, but from what Allah (s.w.t.) has bestowed
upon them. Hence, a Muslim involved in business should recognize
two points: first, that he does not have absolute ownership of the
property he possesses, and secondly, that he cannot use all of his
property as would a trader who separates part of his property to
reinvest in his business as added capital. This is due to the fact that
he has the obligation to allocate part of the property to paying zakat
and offering charity. The business undertaken by the Believers will
neither fail nor fluctuate as Allah (s.w.t.) has assured them the return
and even added something to the return out of his own bounty
(Ali, 1989). Business carried out with honesty and trustworthiness
will lead to the earning of profits in this world as well as in the
Hereafter. This is in accordance with a Hadith narrated by Tirmizie
(d. 279H/893), who reported the Prophet (p.b.u.h.) as having said:

The truthful, honest merchant is with the Prophet, truthful and

martyrs. (Narrated by Tirmizie)

Besides the concept of honesty, Islam also emphasizes

trustworthiness. This concept is a message conveyed by Allah
(s.w.t.) in Surah an-Nisaa, verse 58:

Allah doth command you to render back your trusts to those to whom
they are due; and when ye judge between man and man, that ye judge
with justice: verily how excellent is the teaching which He giveth you!
For Allah is He Who heareth and seeth all things. (Q4: 58)

Apart from the above verse, verse 27 of Surah al-Anfaal also touches
on trustworthiness. In this verse. Allah (s.w.t.) says:

O ye that believe! Hetray not the trust of Allah and the Messenger, nor
misappropriate knowingly things entrusted to you (Q8: 27)

In the process of conducting business, Islamic banks should by right

pay careful attention to the resources involved and the way the
banks attain their income. This is of paramount importance because
 OBJECTIVES, PHILOSOPHY AND PRINCIPLES Ol ISLAMIC BANKING 123

Islam has always emphasized lawful earnings of livelihood. Surah

an-Nisaa. verses 29 to 30 of the Quran, state:

O ye who believe! eat not up your property among yourself in vanities:

but let there be amongst you traffic and trade by mutual goodwill:
Nor kill (or destroy) yourself: for verily Allah hath been to you most
merciful! Ifany do that in rancour and infustice - soon shall We cast
them into fire: and easy it is for Allah. (Q4: 29-30)

Based on the requirements of the religion, Islamic banks are required

to have control over their spending. The amount spent should
be according to what is required and necessary. This means that
expenditure should not exceed benefits to be acquired. Wastage,
which occurs when expenditure does not match potential returns,
is forbidden in Islam. Islamic banks are also obligated to contribute
to the benefits of the Muslim ummah but contributions need not
necessarily be in the form of cash. The command to avoid wastage
and to spend in beneficial ways is found in Surah al-Baqarah,
verse 219:

They ask thee concerning wine and gambling. Say: "In them is great
sin, and some profit, for men: but the sin is greater than the profit."
They ask thee how much they are to spend: say: "What is beyond your
needs." Thus doth Allah makes clear to you His signs: in order ye may
consider. (Q2:219)

Surah an-Nisaa, verse 36 also outlines the right conduct for Muslims
and which is applicable for Islamic banks in conducting their
business and seeking potential clients. It says:

Serve Allah, and join not any partners with Him: and do good Io
parents, kinsfolk, orphans, those in need, neighbours who are near,
neighbours who are strangers, the companion by your side, the wayfarer
(ye meet), and what your right hands possess: for Allah loveth not the
arrogant, the vain glorious. (Q4: 36)
Tlie above verse points out that the Islamic bank must be sensitive
to those in need of help and should aspire to help them. A similar
command is found in Surali al-Baqarah, verse 215:

They ask thee what they should spend (in charity). Say: Whatever ye
spend that is good, for parents and kindred and orphans and those in
want and for wayfarers. And whatever you do that is good - Allah
knoweth it well. (Q2: 215)

Surah an-Nisaa, verse 36 and Surah al-Baqarah, verse 215 accord a big
responsibility to Islamic banks to help those in need. The assistance
may be required by two parties, that is, the party that uses the bank
as a place to deposit their money, and the other being the individual
or trader who acquires financial assistance from the bank in the
form of financing facility. It is therefore the responsibility of the
bank to render help to both groups. A command related to this is
found in Surah al-Maidah, verse 1:

O ye who believe! Fulfil (all) obligations.,. (Q5: 1)

The term "uqud" or "obligation" in this verse carries a wide

meaning. It can include obligations which are explicit or implicit.
An explicit obligation refers to the declaration given by an Islamic
bank to certain parties, whether government or public. This
obligation may be in the form of the establishment of goals and
functions set forth in the article and memorandum of association of
its establishment. An implicit obligation, on the other hand, refers
to all the responsibilities that the bank must fulfil as an institution
using the name of Islam and managed and handled by Muslims,
encompassing man's responsibility to Allah (s.w.t), to the Prophet
(p.b.u.h.), towards himself, towards other people, towards society
and towards the real world.
Although an Islamic bank has the responsibility to render
assistance to those in need, its help can be quite limited. This is
because Islamic banks are at the same time responsible for ensuring
the security of the money entrusted to them by investors and
 objectives, riinosorin and ekincieies or Islamic banking 125

depositors. Thus, they have to carefully prioritize their contribution

and assistance.
There are also verses that command Islamic banks to be just
in all their activities. Apart from Syrah an-Nisaa, verse 29 (Q4: 29),
verse 135 in the same Surah also touches on this issue. It says:

O ye who believe! Stand out firmly for justice, as witnesses to Allah,

even as against yourself, or your parents, or your kin. and whether it
be (against) rich or poor: for Allah can best protect both. Follow not
the lusts (of your hearts), lest ye swerve, and ifye distort or decline to
do justice, verily Allah is well-acquainted with all that ye do.
(Q4: 135)

The command to do justice is also stated in Surah an-Nahl, verse 90:

Allah commands justice, the doing of good, and liberality Io kith and
kin, and He forbids all shameful deeds, and injustice and rebellion: He
instructs you, that ye may receive admonition. (Q16:90)

When this concept of justice is extended into the banking sphere, in

actuality there would be no discrimination issues among customers
as Islamic banks must treat their customers equally. Further, when
Islamic banks ascertain the profit ratio or impose charges on either
their investors or their business partners, justice should be the
underlying guide. The Islamic bank is forbidden from taking extra
payments from its customers as stated in Surah al-Maidah, verse 87:

O ye who believe! make not unlawful the good things which Allah
hath made lawful for you, but commit no excess: for Allah lovcth not
those given to excess. (Q5: 87)

Mannan (1986) was of the opinion that in an Islamic social system,

welfare is maximized only if economic resources are allocated
such that it is impossible to make one individual better off without
making someone worse off within the context of the Quran and
Hadith. Hence, anything which is not expressively forbidden in the
Quran and Hadith but which is consistent with the spirit may be
126 CHAPTER 3

deemed Islamic. Mannan therefore concluded that it is not harmful

for Islamic banks to undertake such activities so long as they are
not prohibited in the Quran and Hadith. In Islam, the absolute
ownership of everything belongs to Allah (s.w.t.) as stated in
Surah Alt Imran, verse 189:

To Allah belongeth the dominion of the heavens and the earth; and
Allah hath power over all things, (Q3:189)

This absolute ownership does not reflect that Allah (s.w.t.) has
created everything for Himself. On the contrary, it is stated in
Surah al-Baqarah, verse 29 that,

It is He who hath created for you all things that are on earth: then He
turned to the heaven and made them into seven firmaments. And ofall
things He hath perfect knowledge. (Q2: 29)

Mannan (1986) stressed that everything which Allah (s.w.t.) has

created belongs collectively to the whole of human society. Apart
from this, Islam acknowledges and recognizes the legal ownership
by the individual, that is, the right of possession, enjoyment and
transfer of property. However, all ownership is subject to moral
obligations. As a matter of fact, even animals have the right to
share. This moral obligation is stated in Surah az-Dhariyat, verse 19,
which says:

And in their wealth and possessions (was remembered) the rights

of the (needy.) him who asked, and him who (for some reason) teas
prevented (from asking). (Q51: 19)

Good deeds or kindness in the real sense is not only rendered to

the poor and needy, but also to those in need who are unable to
present their request due to particular reasons. Those who are truly
charitable will help this latter group. There are several reasons why
people in need of assistance do not request for it (Ali, 1989):
 OBitCTivES, nniosorin ano ■■niNciriES or ISLAMIC banking 127

(i) They are ashamed to ask for fear of losing their self-esteem,

(ii) They are influenced by idealistic patterns of thought, so much

so that requesting for help does not cross their minds.

(iii) They have no knowledge that they actually need help,

particularly when to them it is spiritual wealth that matters.

(iv) They are not aware that there are others who possess something
which could fulfil their needs.

(v) They are ignorant and weak. Here, welfare is in terms of

assistance accorded by the able to the less able.

As for Islamic banks, while making profit is acceptable, the

accumulation of profit without utilization for the betterment of
tile community is forbidden. Based on this revelation, Islamic
banks are expected to be more sensitive towards the needs of the
Muslim society, promote more social welfare programmes and
activities, and make more contributions to the poor and needy.
Islam forbids the accumulation of wealth or the unrestricted
possession by individuals exclusively for their self-interest. In fact,
Islam commands that property or wealth acquired bv lawful means
not be hoarded in selfish interest because it could hinder economic-
growth and result in social imbalances.

In Surah Ali Imran, verse 180, Allah (s.w.t.) says:

And not let those who covetously withhold ofthe gifts which Allah hath
given them of His Grace, think that it is good for them: na, it will be
worse for them: soon shall the things which they covetously withheld
be tied to their necks like a twisted collar, on the Day ofJudgement. To
Allah belongs the heritage of the heavens and the earth: and Allah is
well-acquainted with all that ye do. (Q3:180)
128 CHATTER 3

It is repeated in verses 1 to 4 of Surah al-Humazah:

Woe to every (kind of) scandal-monger and backbiter, who pileth tip
wealth and layeth it by, thinking that his wealth would make him last
forever! By no means, he will be sure to be thrown into that which
breaks to pieces. (Q104:1-4)

The above revelations serve as a reminder to those who manage

Islamic banks to be more cautious in managing assets. The banks
are prohibited from accumulating assets without appropriate
grounds. Wealth of Islamic banks should be spent on the needy
and for the betterment of the society. The failure to do so may
result in the destruction of the wealth accumulated by the banks.
The destruction may be in the form of failure to smoothly manage
the banks, untrustworthy workers, clients not clearing their debts,
investments faced with losses, and so on. These are the factors
which can lead to great losses to a bank, and may ultimately force
it to cease operations.

OPERATIONAL PRINCIPLES
OF ISLAMIC BANKS

As with conventional financial institutions, the primary function

of the Islamic bank is to channel savings to those who have the
need and capability to use it for beneficial causes. Due to the fact
that Islam forbids the giving and receiving of riba, the Islamic
bank must provide its potential customers with banking services
which are permissible in Islam. The first step that should be
taken before offering any service is to refer to the authentic and
fundamental sources in Islamic law. namely the Quran and Hadith.
All forms of principles and prohibitions related to business must
be studied closely. In the Quran, there are many verses related to
 oBiecrtvts, riiiiosorm ani> principles or Islamic banking 129

trustworthiness, justice, prohibition against briber)', giving truthful

evidence, ensuring accurate weights and measures and other such
matters. In addition, there are verses which say that contracts must
be in written form and executed in Jhe presence of witnesses, and
warranties must be provided and every responsibility fulfilled.
There are also guidelines provided by the Hadith, particularly
on matters related to sale and purchase. Some of the relevant Hadilli
are those regarding sii/awi (sale and purchase whereby payment
is made earlier and the item is delivered later), hire, al-hawala (the
transfer of debts from one person to another), loans, repayment of
loans, freezing of assets, bankruptcy, partnerships, lease, witnesses
and terms of business. However, although there is a whole range
of verses in the Quran as well as many Hadith related to the basics
of business, the principles outlined sometimes do not seem to have
direct relevance to the world of modem banking. Hence, it is up to
scholars and jurists (experts in Islamic legislation) to take up the
responsibility to establish principles in business which do not violate
rules of Syariah and at the same time are applicable and relevant to
the banking system.
Various terminologies are used by Islamic banks worldwide to
describe Syariah principles for particular services offered by the banks
concerned. Some banks use Arabic terminologies, some use a mixture
of Arabic and English, while others use tire local language of the
country where the Islamic bank operates. A discussion on the Syariah
principles used by Islamic banks in particular countries is presented
in Chapter 6. Whatever tire terminologies used, Syariah principles
in Islamic banking system can be classed into five categories. The
first category is profit-loss sharing principles; the second is sale and
purchase principles; the third is principles on which fees or charges
are based. The fourth category comprises free services principles and
the fifth category is ancillary principles.
Some of the principles generally used by most Islamic banks are
mudharabah, musyarakah, murabahah, ijarah, ijara wa-iqtina, bat muazzal,
istisna, qard hassatt, wadialt and rahn, Besides these, there are other
130 CHAI-TEH 3

principles which are used by Islamic banks in certain countries

only. For instance, Malaysia has additional principles such as bai
al-dayn, al-ijarah, thumma al-bai, al-wakalah, al-hiwalah, al-ujr and
al-wadiah yad dhamanah. Meanwhile, Iran has additional principles
such as jo'alah, muza'arah and masaqat. The use of this range of
Syariah principles can sometimes cause doubt and confusion,
and raises the question of whether the principles used are in fact
adopted by Syariah or whether they are merely hila (plural: hiyal).
Hiyal are instruments created to achieve certain objectives which
are basically in conflict with Syariah. Not all Islamic jurists take the
same stand on the question of recognizing the concept of hiyal in
creating Syariah principles. The Hanafi School of Law supports the
use of this concept; most of the writings in support of this concept
are by the Hanafi jurists. In the case of the scholars of Shafiis,
support is given by later jurists, and their stand is actually against
that of the Shafiis.
Two other schools of law have objected to the use of the hiyal
concept. This objection was more significant when the Malikis
established the saddadah-dhara'i principle which is essentially a
principle that impedes any usage of methods permitted by legislation
to achieve objectives which were initially haram (unlawful). There
has also been massive outcry from the Hanbali jurists who stronglv
oppose and condemn the use of the concept.

The Musyarakah Principle

Musyarakah or syarika means partnership in English. Syariah divides
syarika into two categories, that is, syarikat nitilk and syarikat aqd.
Another form of partnership is termed mudharabah, but this principle
is normally discussed separately in most Islamic law books. In
general, syarikat niulk only involves joint ownership of certain
properties and it does not involve any joint venture to develop or
amalgamate the properties concerned. Syarikat 'aqd, on the other
 objectives, rHiLosorjn ano i-kincii-i.es of Islamic banking 131

hand, emphasizes the concept of joint exploitation of capital and

the joint participation in profits and losses (Saleh, 1986).
There are three methods of establishing syarikat 'aqd. If money
in the form of cash is the main criterion used to establish the
partnership, then the partnership is called syarikat trial or financial
partnership. Ifthepartnershipdependsontheexperienceorexpertise
of partners, the partnership is termed work force partnership or
syarikat a'mat. If, instead, the partnership is established by virtue
of the credit or investment made in the company concerned, then
tlu- partnership is termed investment partnership or syarikat wujuh.
Partnership may be established either as unlimited partnership,
equal partnership (termed mu/awada among the Hanafis), or as
limited investment partnership or syarikat 'man.
In the context of Islamic banking, the musyarakah principle which
is of relevance is inati syarikat trial or limited financial investment
partnership. This principle is also better known as financing
participation, because money in the form of cash is the main
criterion that must be met for this partnership to exist. In simple
terms, musyarakah means a joint-venture agreement between two
parties to engage in a specific business activity or specific project
with the aim of making profit. The termination of the agreement
may be based on time or after fulfilment of certain conditions. Under
this principle, both parties will provide the capital and the investor
or lender may also participate in the management. Allocation of
profit or loss is determined in advance and is not necessarily based
on the total capital contributed by the partners involved.

The Mudharabah Principle

Mudharabah is the terminology most frequently used by Islamic
banks. This principle is also known as qirad or muqaradah. Scholars
have produced various translations for this word. Among the
translations are trust finance, profit sharing among trustees, equity
132 CHATTtH 3

sharing and profit sharing. Basically, under this concept, those with
capital or money (investor) would assign their money to another
part}' (entrepreneur) to carry out a venture or business. The investor
would not be involved in the business and at the end of a stipulated
period, the entrepreneur would return to the investor the principal
and the proportion of profits made. This principle of mudharabah
had actually been in use by the Arabs before the revelation of Islam
and it continues to be used today (Saleh. 1986). A renowned Islamic
jurist, Iman Saraksi, in his book al-Mabsut, offered the definition of
mudharabah and explained how the term was acquired. According
to him:

The word mudharabah was taken from the word darb which means
"(toil) on the face of the earth". The word was termed such because
the mudarib (the user of other people's capital) has the right to a share
in the profit by virtue of his hard work. Apart from receiving profit,
he also has the right to use the capital and work towards fulfilling
his own objective. The people of Madinah called this kind of contract
muqaradah. This word is taken from the word qard meaning "to
submit". In this case, the owner of the capital submits the right on his
capital to the amil (the user of the capital). (Uzair, 1980, p. 45)

Ibn Rushad, in his book Ridayat al-Muftahid, wrote:

There are no differences in opinion among the Muslims regarding the

validity of the qirad principle. This principle had been practised before
the revelation of Islam and Islam permits it. All agree that this principle
is where a person hands over capital to another party for the latter to
use in business. The user of the capital would acquire, according to
certain conditions, a portion of the profit, that is the portion as agreed
by both parlies, whether a third, a quarter or perhaps even half.
(Uzair, 1980, pp. 45-46)

Based on the above explanation, the mudharabah principle may be

defined as an agreement between at least two parties, that is, rabb
al-mal or investor and mudarib or entrepreneur or agent-manager.
 OBJECTIVES, PHILOSOPHY AND PKINCIPLES OF ISLAMIC BANKING 133

Under the agreement, the investor agrees to finance the venture

or to entrust his money to the entrepreneur who is to trade in an
agreed manner and then to return to the investor the principal and
pre-agreed proportion of the profits. The profit ratios are based on
the agreement made at the beginning of the contract, and there is
no guarantee to the investor that the investment would make profit.
In the event of loss as a result of circumstances beyond the control
of the mudarib, the investor will bear all the loss. The mudarib loses
the time and his efforts only.
There is no uniformity in opinion among the mazaahib or
schools of law on the use of this principle in business transactions.
The mazhab of Maliki and Shafii are of the view that mtidharabah
is limited to trade transactions and other trade-related activities.
Mudharabah cannot include manufacturing functions on the part
of the mudarib, because such action is regarded as a contract for
manufacturing and is termed istisna.
Istisna from the perspective of St/ariah is a contract whereby
the buyer requests or asks the seller to manufacture or construct
a specified item using the seller's own raw materials at a mutually
agreed price. This concept is almost similar to the concept of bai
salam, in that it involves items not yet in existence at the time of
the agreement. However, in bai salam, payment is made at the time
of file agreement, while in istisna, payment is made later on the
delivery or completion of the item.
The Hanafis do not object to the application of this principle to
manufacturing activities. The Hanbali mazhab, on the other hand,
allows both the investor and entrepreneur to have two separate
agreements, namely an agreement for manufacturing, using the
istisna principle, and another agreement which uses the mudharabah
principle, as long as these two agreements do not impose condition
upon each other (Saleh, 1986).
The mudharabah principle may be used in the Islamic banking
system for two different situations, namely between the bank and
the supplier of funds, and between the bank and the user of funds.
134 CHAITTK3

In the first situation, the bank acts as mudarib and the depositor
as rabb al-mal. In the other instance, the bank acts as rabb ai-mal
and the entrepreneur as mudarib. This principle is regarded as a
noble principle in the Islamic banking system because it unites two
fundamental elements, finance and human labour, in the context
which is permitted by Syariah. Even though the investor who
provides the capital does not in fact contribute any effort to obtain
returns from his investment, he at the same time is prepared to
bear the risk of losses. If the venture makes profit, then the investor
would get back his capital and his share of the profit. However, in
the event that the venture suffers a loss, not only would the investor
fail to get any returns, but there is also a big possibility that he
would lose his initial capital.

The Murabahah Principle

Basically, murabahah refers to the sale of goods at a price covering
the purchase price plus a profit margin agreed upon by both parties
concerned. This concept transforms the traditional lending activity
into a sale and purchase agreement under which the lender buys
goods whether in the form of raw materials, machines or other
equipment as required by the borrower for resale to the borrower
at a higher price agreed upon by both parties. This concept is also
known as the mark-up price concept. If this concept is adopted,
Islamic banks would no longer use the profit-loss sharing concept
but instead would act as an ordinary business entity involved in the
sale and purchase transactions of traded goods.
All the schools of law accept the mudliarabah principle as an
instrument which is permitted lobe used in business transactions.
I lowever, there are differences in the method of implementation.
The first difference is in terms of the amount of mark-up allowed,
or the amount of profit the bank is allowed to make when the goods
 OBJECTIVES, rillLOSOl'HV AND FB1NCIFUS OF ISLAMIC BANKING 135

are resold to the customers. The second is in terms of the rights or

choices that can be made by the buyers when they find the price to
be too high or unreasonable. For purposes of determining the price
of the goods sold under the inudharfbah principle, the I lanbalis are
of the view that all the expenditure incurred related to the goods
may be totalled to arrive at the selling price. 1 lowever, the buyers
need to be informed of this total amount and the sources of the
extra expenditure incurred. Although the same concept is held
by the Shafiis an additional requirement is included whereby the
payment to a third partv' by the seller cannot be included in the
mtirabahah price unless agreed upon by the buyer. The Hanafis are
more flexible in that they allow for the inclusion of all expenditure
involved in the business which is related to the murabahah goods.
The Malikis, meanwhile, divide expenditure into three
categories. The first category is expenditure which can be added to
the capital (the selling price of the goods) and this becomes the basis
for calculating profit. The second category is expenditure that can
be added to the capital but cannot be made the basis for calculating
profit. The third category is expenditure that cannot be added to
calculate profit.
According to the Shafiis, when a buyer under the principle of
»iuraba/nih finds that the selling price is too high or has been raised
by the seller without acceptable grounds and the goods are still
with him, then he has the right to return the goods and get a refund.
Another choice that the buyer has is to keep the goods and submit
a claim on the amount raised. Similarly with the Malikis, the buyer
has a choice to buy the goods at a reasonable price or return it. The
Hanafis opine that the buyer has to decide whether to go ahead
with the purchase at the price given or to return the goods and
get a refund. However, if the goods are no longer in the buyer’s
possession, then the buyer has no other option but to accept the
purchase (Saleh, 19K6).
136 CHAPTtK 3

The Ijarah Principle

ijarah means a contract to lease or rent or hire. The actual meaning
of ijarah is therefore a contract or sale involving the use of property
owned by a different party. Under Syariah perspective, a number of
rules apply here. The first rule is khiyar al-ru ya, which is the right to
revoke the contract at the time the goods are seen by the buyer. The
second is khiyar al-'ayb, which is the right to revoke the contract due
to the goods being of an inferior quality. The third is khiyar al-shart,
the right of revocation. The fourth is fasakli, which is revocation
or nullification, and the last is ikala, which is compensation or
replacement.
The Malikis consider ijarah to be similar to a sale contract where
price is exchanged with munafa'a or use of a good. The contract
must determine whether the muitafii'a is based on time (period the
goods are used) or based on goods. According to the Malikis, the
ijarah contract may be invalid in two situations. First, it is not valid
if the goods rented or leased are used for purposes forbidden by
Syariah such as using a property as a place for immoral activities
or gambling, or to produce liquor and other forbidden goods.
Secondly, the contract is considered invalid if it is mandator)- in
nature such as hiring a mother to breastfeed her own child.
The I lanafis define ijarah as a contract for tangible goods or ayn.
for purposes that are permitted by Syariah and for a fixed period.
Meanwhile, the Shafiis regard ijarah as a contract on leased or rented
goods which can be determined from the onset File goods must be
permissible by Syariah. can be transferred and provide fixed return
or fixed rent payment. The Hanafis, on the other hand, regard ijarah
as a contract whereby the owner of the goods grants the lessee the
right to use them in return for a payment. The goods must possess
‘ayn and their use is permissible in Islam.
All tiiazaahib or schools of law agree ijarah is a binding contract
or lazim. There are, however, conflicting views regarding the
revocation of an ijarah contract. The Malikis and Shafiis are of the
 OBIECTIVtS, I-IIIIOSOI'HY ANO PKINCiriFS Or ISl AMIC HANKING 137

view that ijarali can only be revoked if there are major defects on
rented or leased goods. In addition, if the rented or leased goods
no longer serve their purpose, then the contract shall be revoked.
The Hanafis are of the view that ijqrah may be revoked if there are
acceptable reasons to do so, while the Hanbalis opine that ijarah
may be revoked if the rented goods are destroyed or have major
defects. Ijarah may be seen as based either on the period of time
or on the task intended to be implemented. If the ijarah is based
on time, then the time must be stated clearly and the time frame is
reasonable. There are several conditions which should be complied
with if the rental involves agricultural land. The conditions of rental
which may cause losses to the tenant are forbidden; for instance,
the tenant being required to dig canals to drain water away when
the crops are still in need of water. In the event that the crops are
not yet harvested even though the rental period has expired, the
contract will be valid until the crops are harvested, and the tenant
will have to pay the rental accordingly.
There are also Syariah principles on rent which involve the
agricultural sector. These are the principles of mozaraah and
masaqat. Under these principles, payment of rent is based on the
ratio of the crop production. Both these principles are used in the
Iranian Islamic banking system. Mozaraah is the contract between
tire landowner or mozare, who would grant his land for a certain
period to another party, the entrepreneur or itntel, for agricultural
purposes. In return, both parties would share the yield based on
the ratio agreed. Masaqat, on the other hand, is a contract between
the owner of the crops and the iiniel, for the purpose of reaping the
harvest. The yields can be in the form of fruits, leaves or flowers,
and will be jointly shared between both parties (1 ledayati. 1993).
Another concept is the ijarah wa-iqtina concept. This concept
involves the renting of a property, whether moveable or permanent,
with the choice to own it. In the event that the tenant wishes to own
the property, the rental payments prior to it would be regarded as
part of the purchasing price. In Malaysia, the j/ara/i wa-iqlina concept
138 CHAPTER 3

is similar to the al-ijarah thumma al-bai concept in which rental is

followed by sale and purchase. This concept involves two separate
contracts, a rent/lease contract and a sale/purchase contract. In the
first contract, the customer agrees to rent within the agreed time
period. At the end of the rental period, the customer then agrees to
purchase the property from its owner at a mutually agreed price
(Bank Negara Malaysia, 1994). There is another ijarah concept
practised in Malaysia, namely the al-ijarah al-muntahiah bit-tamlik
concept. This concept refers to leasing ending with ownership to
the lessee.

The Qard Hassan Principle

In Malaysia this principle is termed al-qardhul hasan, in Iran as yard
al-hasanah and in Pakistan as qarz-e-hasna. It is a benevolent Ioan that
obliges a borrower to repay the lender the principal sum borrowed.
The borrower, however, has the discretion to reward the lender by
paying any sum over and above the principal amount borrowed.
This principle is the only form of loan permitted by Svariah, and is
meant for social and economic justice. Allah (s.w.t.) says in Surah
al Hadid, verse 11, that:

Who is he that will loan to Allah a beautiful Loan? For (Allah) will
increase it manifold Io his credit, and he will have (besides) a liberal
Reward. (Q57:11)

As suggested by Saleh (1986), Islamic banks are recommended to

offer such loans in the following situations:

(i)This facility may be provided if the banks' loans are mostly

based on musyarakah. If al) financing given is based on
inusyarakalt, there is a high possibility that the banks would
receive a greater percentage of profit compared to the
customers. Loans in the form of yard hassan can be used to
finance working capital.
 OBJECTIVES, rillLOSOl'HV AND PRINCIPLES OF ISLAMIC BANKING 139

(ii) Facilities under tins principle may be offered to customers

with cash flow problems. This type of facility can be offered to
customers whom the banks have investment interest or where
the customer is trustworthy and has high creditworthiness.

(iii) This facility may be provided to customers that have large

deposits with the banks. Faced with financial difficulties, these
customers would normally choose to either withdraw their
savings or request for financial assistance from the banks.
Hence, in order to avoid possible problems and to safeguard
the image of the banks, the qard liassan facility may be offered
to them.

The qard hassan principle has indeed been used widely by Islamic
banks in fulfilling their social responsibility. For instance, Jordan
Islamic Bank uses this principle to help clients who are faced with
financial difficulties. This type of financing is also used to promote
and aid micro enterprises.

The Wadiah Principle

Wadiah or "trusteeship" refers to an agreement between the owner
of assets and another party, whereby the owner gives consent
to the custodian to make use of the assets as long as these assets
remain in the custodian’s hands. Under this principle, the owner
w’ould appoint another person as the keeper or custodian of his
property which implies a trusting bond between the owner and the
custodian. The appointment of the custodian must be done by the
property owner or members of his family. Should the custodian fail
to return the property or if he denies that he has been entrusted
with the safekeeping of it, he would be considered as to have taken
the property illegally and would be held responsible for his action.
The same applies if the custodian mixes his own property with the
property entrusted to him.
140 CHATTER 3

In Islamic banking system, wadiah is an agreement whereby

a customer deposits his money or other items with the bank for
safekeeping and the bank must seek permission from the customer
to use the deposit at the bank's own risk as long as the funds remain
with the bank. The customer may withdraw in part or in whole the
deposit at any time he desires and the bank guarantees to honour
such requests. In Malaysia, this principle has been extended and
is termed al-uwiiah yad dhamanah, which means safekeeping with
guarantee. This concept refers to deposit made by an owner for
safekeeping by someone else. Wadiah involves the safekeeping of
money, among other items where the custodian acts as a guarantor
and thus, guarantees to pay or return the full amount of the deposit
or part of it when requested. The depositor will not receive any
profit, but the Islamic bank may provide gifts or hibah to the
depositor as a token of appreciation and gratitude for his deposit.

The Rahn Principle

Rahn means pledge or pawn. Rahn is a contract of security. Under
this contract, the creditor secures a loan through a pledge of personal
property. The contract becomes binding when possession of the
pledge has taken place. Ownership of the security remains with the
original owner (the creditor) and is not transferred to the pledgee
or pawnee. The transfer of ownership occurs only under certain
conditions as stipulated in the contract. The pawnee or pledge is
held responsible for the pledged asset according to whichever is
lower between the value of the property and the credit provided.
But in the event that the asset is lost due to his fault, then he is
held responsible for its actual value and he has the responsibility to
return the whole amount when the debtor has fully paid his debts.
If the debtor fails to pay the debt when it reaches maturity, then the
pawnee or creditor is entitled to demand the sale of the pledged
asset in order to recover the debt from the sale proceeds. Where
 OBIBCnVFS, I’HILOSOl'HY AND l-HINCII-LES O» ISLAMIC BANKING 141

the proceeds are insufficient to cover the debt, the debtor is still
obligated to repay the remaining amount. On the other hand, any
surplus proceeds must be returned to the debtor or owner of the
asset.

Other Principles
Apart from the principles already mentioned, there are other
principles being used by Islamic banks worldwide. It needs
to be reminded here that the use of these principles is not
all-encompassing; some principles are used by Islamic banks in
only a few countries, while others are used only by particular
countries. In addition, a number of principles have only just
recently received approval from the Syariah Supervisory Council
of certain countries. The following are some of the principles
found in the Islamic banking system:

Bai bithaman ajil

The bai bithaman ajil principle or formerly known as al-bai

bithaman ajil, refers to sale with deferred payment. It is used
widely in Malaysia and is similar to the murabahah principle,
except that under the murabahah principle, payment is made
immediately while in this case payment is deferred. This
principle is sometimes termed bai muajjal.

Bai al-ifayn

Bai al-dayn means debt trading and it refers to the financing of

debts. Under this principle, financing is made based on sale and
purchase of trade documents. Financial resources are provided
for the purpose of production, trade and services. Transactions
can only be done on documents which authentically show that
trade does exist.
142 CHAFII K 3

Bai al-inah

This principle involves a sale contract whereby the seller sells

his assets to a buyer and at the same time agrees to repurchase
the assets from the buyer. The seller sells his assets on credit to
the buyer and later repurchases it at a cash price. The repurchase
price is normally lower than the agreed selling price. Some
mazhab do not approve the use of this principle in the Islamic
banking system.

Bai istijar

This is a sale and purchase contract whereby an agreement

is made between two parties, the seller and buyer. Under the
contract, the buyer agrees to buy on a continuous basis, and
there will not be any more bargaining between the buyer and
seller after the initial agreement is finalized.

Bai salam

This principle involves a sale and purchase contract made

between two parties, the seller and buyer. Under the contract,
the buyer agrees to make an advance payment but the asset is
delivered at a later date.

Hitvalah

The hiwalah refers to a transfer of funds or debt from the

depositor's or debtor's account to tire receiver's or creditor's
account. The bank charges commissions for the services
rendered.

Istisnu

This is a sale and purchase principle whereby an agreement

is made between two parties, the seller and buyer. Under the
contract, the buyer agrees to buy non-existent goods which are
to be manufactured or constructed by specification or order.
 OBIECTIVtS, l-HIIOSOrm AND I'KINCIMES OF ISLAMIC BANKING 143

The buyer can pay either at the beginning of the contract or

when the goods ordered are ready to be delivered. Hence, this
principle is also sometimes known as a contract to manufacture
or produce. This is in contrast to the salam principle whereby
the goods intended to be bought need not necessarily exist nor
be produced. Also, under salam, the buyer has to provide full
payment at the initial stage of the agreement. Under an istisna
contract, the goods intended to be bought must be produced
by the manufacturer. The istisna contract cannot be terminated
when the goods are in the process of production.

Jo'alah

Jo'alah refers to service charge. This principle is practised

in Iran. A person called ja'el or employer pledges to pay a
specified amount of money to another party, the jo'al, who will
offer certain services according to set terms. The party who will
provide the services is called the ante! or contractor.

Kafalah

Kafalah means guarantee. According to this principle, guarantee

is provided by a person to the owner of a property, who has
placed or deposited his property with a third party. In the event
that a claim is made by the property owner on the property
submitted to the third party, and the third party fails to fulfil the
claim, the guarantor will have to take over the responsibility of
fulfilling the claim.

Musawamah

This principle involves sale and purchase transactions and is

similar to mudharabah, except that no reference is made to the
buyer as to the cost price and there is no need for the seller to
disclose the cost price.
144 CIIATTEH 3

Sarf

Sarf is a contract involving the buying and selling of foreign

currencies, that is, the exchange of one currency for another.
However, some mazhab do not allow money exchange if it
involves forward contract transactions, that is, transactions at
a specified future date at a price (exchange rate) that is fixed on
the purchase date.

Uir

This principle refers to fees and commissions charged for

services rendered.

Urban

This is taken from the concept of bai al-urbun which means to

pay or receive in advance. Under this principle, the buyer buys
a commodity and pays a deposit for it. In the Islamic banking
system, the deposit may be used by the bank to carry out certain
responsibilities on behalf of its customers. It is also used in the
capital market, involving the options to buy or sell a security.
Those given the right to the options are required to pay for that
right, and that payment is based on the principle of urbun.

Wakalah

Wakalah means representative. The principle refers to the

situation where a person appoints another person to represent
him in a transaction.

Tawarruq

This is a reverse murabahah line of credit. This principle involves

two levels of transaction. First, a buyer buys on credit from the
original seller. Then the buyer resells the commodity for cash to
a third person.
 OBIECHVES, philosophy and ruiNcii’iis 01 isi amic banking 145

PRIORITIES IN THE USE OF SYARIAH

PRINCIPLES

It is the consensus among Muslim scholars that the various

principles adopted by Islamic banks can be classed into two
categories, namely principles which are advocated, or strongly
Islamic, and principles which are not advocated, or weakly Islamic
(Mirakhor, 1987): Strongly Islamic principles are those that conform
to Islamic objectives both in form and substance. The weakly
Islamic principles refer to practices which conform to Islamic norms
in form but not in substance. The basis for judgement as to the
strength or weakness of a given principle is the extent to which that
mode contributes towards achievement of the objectives of Islamic
economics. Hence, only those principles which permit risk-return
sharing between providers and users of funds can be considered
strongly Islamic. Muslim scholars consider only two principles,
that is, musyarakah and mudharabah, as strongly Islamic. 1 lowever,
most scholars recommend that the remaining principles be applied
in cases where risk-return sharing cannot be implemented.
Nevertheless, most Islamic banks apply the recommended
Syariah principles for deposit facilities only, particularly the
investment account facilities. With regard to uses of funds, the
principle of profit-sharing is not applied much at all. For example,
the percentages of musyarakah and mudharabah for Bank Islam
Malaysia at the end of June 2007 and end of June 2006 were 0.6%
and 0.7% of the total financing, respectively. The percentage of
fund devoted to this mode of financing for Qatar Islamic Bank
was 4.2% for the period ending 2006, and the percentage increased
significantly to 10.7% at the end of 2007. Dubai Islamic Bank has the
highest percentage of financing in this category whereby the total
financing was 19% and 16.7% of the total financing for the periods
ending 2007 and 2006, respectively.
146 CHARTER 3

While Muslim scholars are constantly suggesting that

profit-sharing principles are the preferable principles, Islamic
banks seem to prefer the non-advocated principles. According to
them, this may be because of their simplicity, the risk aversion of
Islamic banks and the fact that the rate of returns can be determined
at the beginning of the financing period. The murabahah and ijarah
principles, for example, are implemented based on percentages
in determining the mark-up price of goods. Some principles
practised by Islamic banks are similar to those of their conventional
counterparts, particularly the emphasis on the creditworthiness of
customers and the upholding of the creditor-debtor relationship.
There is a danger that some of these principles could be misused as
means for opening a backdoor for riba (Ahmed et al., 1983).
The views expressed by the Muslim scholars are, however,
not shared by financial authorities in Islamic countries The latter
believe that solely applying the concept of profit-loss sharing in the
Islamic banking system implies that the banking system is headed
for an unclear course. Furthermore, the Islamic banking system has
to be implemented in a vigilant manner so as to ensure the success
of the endeavour. Bank Markazi Jomhouri lslami Iran, the Central
Bank of Iran, in its 1984 Annual Rejiort stressed:

Money in the bank is owned by depositors who are of various shapes

and sizes; there are rich people there as well as the ordinary person
with a deposit ofas little as IRR 1.000 m his account. The bank, which
acts as the trustee, will then channel this money Io debtors. Hence,
the system must be capable of protecting the depositors and providing
them with sufficient returns. If the depositors are not protected, then
the system is considered unjust because of the absence of the concept
of 'adl or justice, whereas concept is important in any Islamic system
(Mirakhor, 1987, p. 186).

Based on the above statement, it is clear that even though the

majority of Muslim scholars recommend the wide use of the
profit-sharing principles, Islamic banks do otherwise. They believe
 OBJECTIVES, rillLOSOI-HV ANO l-KINCITLES Ol ISLAMIC BANKINC. 147

that Islamic banks, acting as trustees, should be concerned about the

security and soundness of the banks which in turn are dependent
on the degree of risk taken. This is why the profit-loss principle is
less used compared to other principles.

SOURCES AND USES OF FUNDS

Besides their own capital, Islamic banks are dependent on depositors'

money, which is a major source of funds. Conventional banks offer
deposit facilities on the assumption that a person has money to
hold or keep. According to the Keynesian approach, people hold
money for three reasons, namely transactions, precautionary and
speculative purposes. Hence, the first deposit facility provided is the
current account. This type of deposit facility is for those who need
money for transaction purposes. This facility offers the convenience
of withdrawing funds by cheques. Hence, depositors do not place
importance on returns or interest. When offering the current
account facility, the bank would normally impose a service charge
and other mandatory charges like stamp duty, tax and others where
applicable. However, due to increasingly strong competition, some
banks have started to provide returns on current accounts. There
are, however, certain conditions to be fulfilled before the account
holders are entitled to receive interest.
Since this account can be devoid of the interest element, Islamic
banks are permitted by Syariah to offer similar facilities. The yard
hassan or wadiah principles arc among the Syariah principles which
are used by Islamic banks in providing this facility. The depositor is
allowed to withdraw his money any time he wishes to do so. This
is intended to instil confidence in the depositor that Islamic banks
guarantee the deposits made.
The second deposit facility is termed savings account. In
conventional banks, savings accounts cater to the needs of those
148 CHATTER 3

who wish to save money but at the same time want to eam
an income. Depositors of savings accounts hold money for
precautionary' motives. At the same time, they are also induced by
their investment motives. These depositors are usually from the low-
income group and those with salaries. The same facility is provided
by Islamic banks using the principles of wadiah, mudharabah and
qard hassan. However, if the mudharabah principle is used, customers
may not be allowed to withdraw their money any time they desire
since the bank uses the deposited money for investment purposes
and depositors will be rewarded based on the profit made.
The third type of deposit is fixed deposit. Such facility is
offered by banks to cater for the investment motives of customers.
These depositors normally have idle funds and are looking for
better returns on their money. In Islamic banking, this facility is
known as investment account or sometimes also called profit-loss
sharing account and is governed bv the principle of mudharabah.
Within this context, the Islamic bank acts as the mudarib and the
depositor as the rabb al-mal. Customers are free to choose the period
they want to place their funds with tire bank. The bank provides
neither guarantee nor fixed return on the amount deposited. Under
the principle of mudharabah, the customer get a share of the profit
made by the bank based on a pre-agreed ratio. The agreement on
how the profit or loss will be distributed between the bank and
the depositor is made at the beginning of the deposit tenure and
cannot be amended during the tenure of the deposits, except with
the consent of both parties.
Apart from deposit facilities, Islamic banks may also raise
funds by way of issuing investment certificates. Unlike normal
investment certificates which have interest rate elements, the
certificate issued by the Islamic bank carries no fixed return. The
principles of mudharabah and qard hnss.ui are applicable for this kind
of facility. In applying the principle of mudharabah, the reward for
the depositors is based on the bank’s annual profit, whereas under
 OBfSCTlVBS, ■■IIIIOSOl-Ht ANO rRlNClrl.l'S Of 1st AMIC RANKING 149

the principle of i/aril hassan, the reward is entirely dependent upon

the bank's discretion.
In Malaysia, Islamic banks may also obtain funding from the
inter-bank money market, where tly?y may trade Islamic financial
instruments. Similar to conventional banks, Islamic banks offer
financing facilities to individual as well as corporate customers.
However, the mechanism used by Islamic banks differs from
that of conventional banks. As entities established on religious
foundations, Islamic banks are expected to abide by whatever rules
and regulations imposed by the Quran and Hadith. On account
of their religious obligations or persuasion, Islamic banks are not
guided by profit-maximizing goals. Instead, the principal goal is
for the betterment of the Muslim ummah and their overall business
philosophy is based on justice and equity. Hence, Islamic banks
have the duty to help those in need, whether they are individual or
corporate customers. Non-commodity trading is strictly prohibited
by Syariah. Since Syariah considers money as a non-commodity item,
granting loans to customers for profit is therefore unlawful (Siddiqi,
1986). Hence, funds accumulated by Islamic banks will mostly be
channelled through equity participation and profit-sharing. The
principles of mudharabah, musyarakah and murabahah are commonly
applied by Islamic banks in assisting their commercial customers
who face inadequate capital. Tire financial assistance rendered
is used either to start a venture or as working capital. The ijarah
principle, meanwhile, is applied for leasing facilities as well as hire
purchase.
Islamic banks also offer a variety' of facilities to individual
customers, whether to ease their financial burden or to help them
purchase assets such as homes or consumer goods. The qard hassan
principle normally forms the base of the facilities that are rendered
to ease the financial burden of customers, while in the purchase
of property and goods, the principles used are mudharabah as well
as bai muazzal (in Malaysia this principle is known as bai bithaman
ajil).
150 C1IATTU 3

The above discussion proves that Islamic banks are capable of

fulfilling the financial needs of customers in terms of both types
and forms of financing required. This does not necessarily imply
that Islamic banks are content with their existing products and
services. The banks are constantly developing new products to suit
the needs of the customers and the market. Other banking services
provided by Islamic banks such as letters of guarantee, money
order, travellers cheques, safe deposits and remittance services are
fee-based services. In Malaysia, these facilities are provided based
on the principles of al-wakalah, al-hiwalah, al-kafalah and al-ujr.

RELATIONSHIP BETWEEN ISLAMIC

BANKS AND THEIR CUSTOMERS

The basic banking functions of Islamic banks, namely, deposit

savings and channelling of funds, are similar to those of the
conventional banks. Services offered are also fundamentally similar
to that of their conventional counterparts. As such, the question
arises as to whether the bank-customer relationship for both
Islamic and conventional banks is similar. For conventional banks,
the relationship is that of creditor and debtor Ihis relationship
was decided upon in 1948. in the case of Foley vs. Hill and others.
For example, in Foley vs. Hill, it was held that when a customer
deposits money into his account, the bank becomes a debtor and the
customer a creditor. In this instance, the money now becomes the
property of the bank since the bank is considered to have borrowed
it from the customer.
In general, the bank has the right to use the money deposited
by customers according to its preferred method. However, the
bank has the responsibility to return or pay the money deposited
upon the request of the customers, along with interest, if any. This
relationship may be terminated with the consent of both parties.
 OBJECTIVES, CHUOSOI'HY AND PRINCIPLES Ol' ISLAMIC BANKING 151

However, under normal circumstances, the decision to terminate

the relationship may be made bv any party in accordance with
the conditions stipulated at the initial stage prior to the inception
of the relationship. Developments jn the world of banking have
changed the relationship between the bank and its customers. It is
no longer merely that of creditor and debtor but has been extended
to include relationships between trustee and beneficiary, lessee and
lessor, and others, depending on the services provided by the bank.
When conventional banks extend debt facility to their customers,
the relationship established is that between creditor and debtor,
whereby each party has rights as creditor and debtor, respectively.
Very few cases of disputes between Islamic banks and their
customers have achieved resolutions in court. In Malaysia, such
disputes are brought to the civil court and not the Syariah court.
Given that the Syariah court is considered not fully ready to resolve
matters regarding muamalat. it is envisaged that the civil court will
continue to play its role for quite some time yet.

Relationship with Suppliers of Funds

The relationship between the Islamic bank and its depositors is not
always that of creditor and debtor. The status of the relationship
is dependent on the principles of Syariah used in creating that
relationship. The relationship of creditor and debtor exists if the
deposit service applies the yard hassan principle. If the wadiah
principle is applied, then the relationship would be that of trustee
and beneficiary, and in the case where the mudharabah principle is
used, it would be that of an investor-entrepreneur relationship.
When the yard hassan principle is used, it means the depositor lends
his money to the Islamic bank without expecting any rewards or
returns. Similarly under the wadiah principle which is based on
trust; the depositor places his money in the bank for safekeeping
based on the belief and confidence that the Islamic bank is a safe
152 CHArrra 3

place. Hence, there is no profit-making motive on the part of the

depositors of current and savings accounts of tire Islamic bank. The
desire to make profit may be present in customers who choose to
deposit their money under the inudharabah principle. Nevertheless,
even if the profit factor does exist in Islamic banking, it should by
no means be the main attraction for customers to patronize Islamic
banks. Islamic banks are business institutions founded on religion;
hence, relationships that exist should also be based on religious
grounds.
Just as Islamic bank does not place profit as its principal goal,
so too should not the customers. This means that Muslims should
not go to an Islamic bank for the higher returns offered compared
to a conventional bank, and vice versa. This point relates to the
fundamental principles that influence the economic decisions of
Muslims. These fundamental principles are tire belief in the Day of
Judgement and life in (he I lereafter, the Islamic concept of richness,
and lastly the Islamic concept of success (Kahf, 1980). These
three principles are expected to have a significant impact on the
decision-making process of Muslims that is related to economic
matters. The first principle has an effect on the depositors'behaviour
and decision-making process of those who strongly believe in the
Day of Judgement and life in the I lereafter. 1 lence. their choice of
action is based not only on the immediate financial return but also
on those returns in the I lereafter As such, their decision to have a
banking relationship with Islamic banks is not to make profit but
rather to gain the blessings of Allah (s.w.t.).
Since Islamic bank is an Islamic institution that operates in
accordance with Synriiih, the depositors' action would gain Allah's
(s.w.t.) blessings. Moreover, the decision to patronize Islamic
bank demonstrates their support for the Islamic bank's goal and
philosophy towards enhancing the welfare of the Muslim ummah.
Such action is also in line with Sttrali at-Taubah, verse 20, which
says:
 <»)H iivfs, rHiLosorm ano munch-luof Islamic hanking 153

Those who believe, and suffer exile and strive with might and main, in
Allah's cause, with their goods and their persons, have the highest rank
in the sight of Allah: they are the people who will achieve (salvation).
, (Q9:20)

Therefore, having jihad (to strive in the cause of Allah (s.w.t.)) as a

motive for establishing a relationship with the Islamic bank ensures
that customers do not place profit above other aspects. Apart from
the above principle, the concept of wealth in the Islamic perspective
could also be taken asa basis in establishing the relationship between
the bank and the customer, as found in Sarah Ali Imran, verse 189
(Q3: 189) which states that everything belongs to Allah (s.w.t.).
Wealth is a bounty from Allah (s.w.t.) and man is encouraged to
strive for wealth, as stated in Sarah al-/uimi ah, verse 10:

And when the Prayer is finished, then may ye disperse through the
land, and seek of the Bounty of Allah: and celebrate the Praises of
Allah often (and without stint): that ye may prosper. (Q62: 10)

Wealth itself is considered an important means by which man

can pave the way for the attainment of his ultimate objective. All
persons are exhorted to work to earn a living and accumulate
wealth. However, in Islam, the methods of earning, possessing and
disposing of wealth must be in line with Syariah. There are many
Hadith which urge Muslims to strive on one’s own and not from
the income generated from other people's effort. The following
is a Hadith collected by Al-Bukhari and narrated by Aishah (the
Prophet's (p.b.u.h.) wife):

The companions of Allah's Apostle used Io practise manual labour, so

their sweat used to smell, and they were advised to lake a bath.
(Khan, 1989, p. 162)

Similarly with the Hadith narrated by al-Miqdam who reported the

Prophet (p.b.u.h.) as having said:
154 CHAPTER 3

Nobody has ever eaten a better meal than that which one has earned by
working with one's own hands. The Prophet of Allah. David used to
eat from the earnings of his manual labour.
(Khan, 1989, pp. 162-163)

in a Hadith narrated by Abu Hurairah, the Prophet (p.b.u.h.) said:

No doubt, you had better gather a bundle of wood and carry it on your
back land earn your living thereby) rather than ask somebody who
may give you or not. (Khan. 1989, p. 163)

In addition to this, Islam does not define the concept of richness on

the basis of riches or property owned- Instead, Islam defines success
as the level of obedience to Allah (s.w.t.) and not the accumulation
of wealth. Service and obedience may be rendered by the positive
use of capabilities and resources given by Allah (s.w.t.). This is
mentioned in the following two Hadith collected by the Prophet
(p.b.u.h.) and narrated by Abu Hurairah:

Verily Allah does not look Io your faces and your wealth but He looks
to your heart and to your deeds. (Siddiqi, Vol. 4. p. 1362)

Richness does not lie hi the abundance of (worldly) goods but richness
is the richness of the soul /heart, self). (Siddiqi, Vol. 2. p. 501)

According to Islamic teachings, if a man really wants to serve

Allah (s.w.t.). tile utilization of the natural resources, property and
riches, or status and position made available to him. must not be
regarded as his privileged right but instead regarded as a duty and
obligation prescribed by Allah (s.w.t.) for him to fulfil to the best
of his ability. This is in line with verse 27 ot Surah al-Anfaal (Q8: 27)
which commands Muslims to fulfil the responsibility entrusted to
them by Allah (s.w.t.) and the Prophet (p.b.u.h.).
With the above three principles as a guide, Islamic banks’
customers are expected not to be influenced by the profit motive
when placing their money in Islamic banks. Instead, they should
regard the reason for placing their monies with the Islamic banks as
 OBJECTIVES, I'HIlOSOrm AND I'KINCiri.ES Of ISLAMIC HANKING 155

getting blessings from Allah (s.w.t.) and this action is considered as

the best way of managing the resources entrusted by Allah (s.w.t.).
Hence, the best method of accumulating wealth is by striving on
one's own and not from the income generated by other people's
efforts. Whatever returns or gains acquired should be regarded as
a gift from Allah (s.w.t.) and should be responded to by a feeling
of deep gratitude (syid.nr) to Allah (s.w.t.). By instilling such
philosophy, customers would not compare returns given by Islamic
and conventional banks. Nevertheless, we have yet to reach the
point where customers do not regard economic returns as a factor
when deciding to patronize Islamic banks. Researches have shown
that many still choose to do their banking business with Islamic
banks due to return and costs factors.

Relationship with Users of Funds

The relationship between the Islamic bank and the users of its funds
depends on the principle used in rendering a particular facility, that
is, whether the facility is based on profit-sharing, sale and purchase,
fees and fixed payments, or services provided free of charge. If the
profit-sharing (mudharabah or musyarakah) principle is used, then
the relationship is that of partners or investor-entrepreneur. If the
sale and purchase principle is used, then the relationship is of a
trader and his customer. For facilities based on the principle of
charges and fees, the relationship is that of employer and employee
or employer and his representative. In tire case of free-of-charge
services, the relationship is of a party who possesses something
which he wishes to give out and a party who wishes to receive it.
As with the relationship between the Islamic bank and supplier of
funds, here the relationship must be founded on relevant religious
beliefs.
Both the Islamic bank and users of funds must place the
fundamentals of the religion as the core in building the relationship.
156 CHAPILR3

Surah al-Maidah, verse 1 (Q5: 1) which calls for all Muslims to fulfil
their responsibilities should be upheld by both parties. The bank
has the responsibility to help those in need, regardless of the status
of the person or the size of the customer’s business, The customers
who receive funds from Islamic banks, meanwhile, are expected
to discharge their liability accordingly. It is surely unjust and
unacceptable when a Muslim who receives financial assistance from
an Islamic bank refuses to settle his financial liability with the bank.
Although in principle, Muslims are obligated to settle their debts, in
reality, Islamic banks too face bad debt problems. If one examines the
annual reports of Islamic banks, one can see that a big part of funds
is allocated for bad debts. This goes to prove that Islamic banks do
have default customers. The relationship built with the Islamic bank
should be founded on a sense of responsibility and honesty. Islamic
banks, on their part, are expected to be more supportive towards
their customers. Customers who face difficulties in meeting loan
repayments should not be treated harshly. This is in line with Surah
al-Bai/arah, verse 280, which says:

If the debtor is in difficulty, grant him time till it is easy for him to
repay. But ifye remit it by way ofcharity, that is best for you ifye only
knew. (Q2:280)

It is also hoped that Islamic banks would be more receptive and

pro-active in the process of creating, moulding and developing
entrepreneurs. The mudharabah principle, for instance, serves as an
incentive for creating new entrepreneurs Muslims who possess
business expertise but who are without capital can approach Islamic
banks for financing. I'he mudharabah principle not only encourages
existing entrepreneurs to explore potential business areas and
opportunities but also inspires new entrepreneurs. Entrepreneurs
who enjoy this facility will benefit in two ways. First, they need
not worry about repayment. The Islamic bank will only receive
its share from the ex-post profit from the business. In the case of
losses, entrepreneurs go unrewarded for their time and effort while
 iBitcnvts, runosorm ami rniNCiriES or imamii banking

the risk of loss is completely borne by the bank. Secondly, since the
Islamic bank acts as a partner, it will provide full moral and financial
support in attaining profit. This is in contrast to the conventional
bank, where the interest factor is fiyd at the beginning of the loan
period, and where the bank is not concerned about the progress
of customers' businesses. This is because the conventional bank
continues to receive payments even if projects fail or face losses.
Another role played by the Islamic bank is in moulding the
entrepreneur towards a more religious and ethical life. This is
effectively done in two ways. First, as an investor or partner, the
Islamic bank is bound by the limitations of Syariah. Hence, the
available funds can only be invested in productive and permissible
investments. Investments that are associated with immoral
activities, gambling, liquor, fortune telling, making of idols and
activities involving riba are considered unlawful. Secondly, Islam
has prescribed principles relating to trade and commerce which
must be followed. As a trader, the business transactions must be
conducted honestly, faithfully and in a beneficial manner. Islamic
banks should ensure effective supervision and monitoring of the
funds disbursed, as entrepreneurs are bound to face challenges
and obstacles. Without effective supervision and monitoring, the
entrepreneur may misuse the funds and conduct unlawful business
practices which would eventually bring about losses io both the
entrepreneur and the bank.

SUMMARY

The initial objective of the establishment of the conventional bank

was to provide a place for people to keep their valuables and to offer
debt facilities to those faced with financial problems. As an ordinary
business entity, profit maximization is the principal objective of the
conventional bank. Interest rates are used to determine returns to
158 CHAPTER 3

be rewarded to the depositors and returns the bank should receive

from the users of funds. Consequently, the conventional bank would
impose a low interest rate on the depositors and a high interest
rate on its debtors. Tire bigger the gap between these two rates, the
bigger the profit gained by the bank, and vice versa. Based on this
concept, the actual profit is partial towards the bank and not the
customers using the service.
In contrast to the conventional bank, Islamic bank is founded
on both profit and religious factors. Hence, while performing its
banking businesses in accordance with Syariah, Islamic bank is
also expected to make profits from its operations and channel this
profit to fulfil its moral or social obligations. However, Islamic
banks differ in the way they discharge their social responsibilities
and obligations. Some banks have clear written statements of
their social objectives and implement various activities towards
achieving them.
As entities based on religious doctrines, Islamic banks must
conform to the philosophies and business principles as highlighted
in the Quran and Hadith. Banking operations must be in consonance
with Islamic teachings. Factors such as justice, equality, trust
honesty, non-prejudice, mutual gain, non-wastage and fulfilling
of responsibility are matters that must be adhered to by Islamic
banks.
Since the giving and receiving of riba is forbidden, Islamic
banks operate on principles that are permissible in Islam. These
principles are grouped into five main categories: profit-loss
sharing principles, sale and purchase principles, fees-based or
charges-based principles, free services principles and ancillary
principles.
Two main principles practised in the category of profit-loss
sharing are mudharabah and musyarakah. Principles involved in the
sale and purchase category are murabahah, bai muajjal, bai bithaman
ajil. bai murabahah, musawamah, istisna and bai salam. The principles
followed under the fees or charges category' comprise the principles
 objectives, rHiiosorm and ruiNcirus or Islamic banking 159

of ijarah, jo'alah, wakalah, kafalah, ujr and hiwalah. The principle of

yard hassan is observed in the free services category, while wadiah
and rahn are ancillary principles which support Islamic banking
activities. The use of the profit-loss sharing principles is greatly
advocated, because of its high benefits in enhancing the economy
of Muslims as a whole. The free services principles are used for
implementing social activities.
The existence of a variety of applicable Syariah principles enables
Islamic banks to offer total banking products and services. Hence,
customers in most Islamic countries have the choice of whether to
obtain Islamic banking sen ices or otherwise. The status and type of
relationship between the customer and the Islamic bank, however,
depends on the Syariah principle applied in the service concerned.
Since Islamic banks apply Syariah principles in conducting their
banking business, Muslims are expected to response favourably
and support the establishment of Islamic banks.
Tile belief in the Hereafter, and the Islamic concepts of wealth
and success should instil in Muslims the spirit of loyalty towards
the Islamic bank. Moreover, with the qualities of responsibility and
honest)- embedded in both the bank staff and customers, there is
every likelihood that the financing operations implemented by
Islamic banks would expand the business of their customers. At the
same time, they would succeed in shaping Muslim clients to become
entrepreneurs who in turn will also practise Islamic principles of
entrepreneurship.

REFERENCES AND FURTHER READING

Ahmed, Ziauddin, Iqbal, M and Khan, M.F. Money ami Banking in

Islam. Pakistan: Institute of Policy Studies, 1983.
IbO CHMHI3

Ali, Abdullah Y. The Holy Quran, Text, Translation and Commentary.

Maryland: Amana Corporation, 1989.

Ali, Muazzam. "A Framework of Islamic Banking." In Directory

of Islamic Financial Institutions, edited by John R. Presley.
London (UK): Croom Helm. 1988.

Al-Zuhaili, Wahbah. Financial Transactions in Islamic /urisprudence.

Vol. I. Translated by Mahmoud A. El-Gamal. Beirut (Lebanon):
Dar al-Fikr, 2003.

Bank Islam Malaysia Berhad. Annual Report (various issues).

Bank .Muamalat Indonesia. Annual Report (various issues).

Bank Muamalat Malaysia. Annual Report (various issues).

Bank Negara Malaysia. Money and Banking in Malaysia. Kuala Lumpur

(Malaysia): BNM, 1994.

Departemen Agama Republik Indonesia. Al-Quran dan

Terjemahannya. Jakarta (Indonesia), 1974.

Dubai Islamic Bank. Annual Report (various issues).

Flstone. R.G. "Objective of Profit-making Intermediaries and of

Co-operative Institution." In Vie Economics and Management
of Financial Institutions, edited by D. Johannes Jutter and
Tom Valentine, 11-21. Melbourne (Australia): Longman
Cheshire, 1987.

Erol. C. and El-Bdour, R. "Attitudes, Behaviour and Patronage

Factors of Bank Customers Towards Islamic Banks." International
lournal of Bank Marketing, Vol. 7. No. 6 (1989): 31-39.

Faysal Islamic Bank of Bahrain. Annual Report (various issues).

I laron. S„ Ahmad. N. and I’lanisek, S. "Bank Patronage Factors of

Muslim and Non-Muslim Customers." International /ournal of
Bank Marketing, Vol. 12, No. 1 (1994); 32—10.
 objectives. runosoriiv and I'Riscirirs or is t amic hanking 161

Hedayati, S.A.A. "Islamic Banking as Experienced in the Islamic

Republic of Iran." Working paper presented at the International
Conference on Islamic Banking, Sydney (Australia), 9-10
November 1993. ,

Islami Bank Bangladesh Limited. Annual Report (various issues).

Jordan Islamic Bank for Finance and Investment. Annual Report
(various issues).

Kahf, Monzer. "A Contribution to the Theory of Consumer

Behaviour in Islamic Society." In Studies in Islamic Economics,
edited by Khurshid Ahmad, 19-36. Leicester (UK): The Islamic
Foundation. 1980.

Khan. M. Fahim. "Islamic Banking as Practised Now in the World."

In Money and Banking in Islam, edited by Ziauddin Ahmed,
Munawar Iqbal and M. Fahim Khan, 259-276. Jeddah (Saudi
Arabia), International Centre for Research in Islamic Economics,
King Abdul Aziz University, 1983.
Khan, Muhammad M. The Translation of the Meanings of Sahili
Al-Bukhari, Vol. 3. Lahore (Pakistan): Kazi Publications, 1989.
Mannan, Muhammad Abdul. Islamic Economics: Theory and Practice
(Foundations of Islamic Economics). London: Hodder and
Stoughton, 1986.
Mirakhor, Abbas. "Short-term Asset Concentration and Islamic
Banking." In Theoretical Studies in Islamic Banking and Finance,
edited by Mohsin S. Khan and Abbas Mirakhor, 185-199.
Houston (Texas, USA): Institute for Research and Islamic
Studies, 1987.
Qatar Islamic Bank. Annual Report (various issues).
Sadeq, A.H.M. Islamic Bunking and Economic Development. Working
paper presented at the international Conference on Islamic
Banking, Sydney (Australia), 9-10 November 1993.
162 CHAPTER J

Saleh, Nabil A. Unlawful Gain and Legitimate Profit in Islamic Law:

Riba. Ghararand Islamic Banking. London: Cambridge University
Press, 1986.
Siddiqi, Hamid, trans. Sahih Muslim. Vols 2 and 4. Beirut (Lebanon):
Dar al Arabia Publishing, Printing & Distribution, undated.
Siddiqi, Muhammad Iqbal. Model of an Islamic Bank. Lahore
(Pakistan): Kazi Publications. 1986.
Uzair, Muhammad. "Some Conceptual and Practical Aspects of
Interest-Free Banking.” In Studies in Islamic Economics, edited by
Khursid Ahmad, 37-58. Leicester (UK): The Islamic Foundation,
1980.

www.albaraka.com

www.alislami.co.ae

www.bankislam.com.my

www.barakaonline.com

www.bi.go.id

www.isbt.co.th

www.islamibankbd.com

www.muamalatbank.com

www.siblbd.com
 CHAPTER

THE CONCEPTS OF INTEREST,

USURY AND RIBA

This chapter discusses in detail the meaning of interest, usury and riba.
This is necessary because there are many definitions given for the word
"interest". Apart from the views ofMuslims, those of the Jews, Christians,
Romans and Greeks will be presented for comparison purposes. Differences
of opinions among Muslims regarding riba will also be discussed.

INTRODUCTION

Islam prohibits the acceptance and payment of riba or charged

interest. Therefore, all operations of Islamic banking must be
conducted without any element of riba. A great majority of Muslim
intellectuals are of the opinion that not only is the practice of riba
immoral, but that it also hinders the growth of society. Riba is seen
to cause one's wealth to erode, to be the source of immoralities and
to create classes in society, thus creating friction. Riba may also

16.1
164 ch*i,tik4

bring about a situation where the rich become richer and the poor
poorer.
Why does Islam prohibit Muslims from accepting and giving
riba? Islam is not the only religion which prohibits its followers
from taking riba. Judaism and Christianity, during their early years,
never condoned their followers' acceptance of interest. In fact, the
Christian Church regarded the acceptance of interest as a serious
sin. In conjunction with the trade and commercial revival in the
12th century, the discussion of interest among Christian scholars
and theologians was conducted on a more scientific basis. Finally,
in 1836 after a series of discussions, the Christian Holy Office in
Rome issued a decree that interest was allowed by law and may be
taken by everyone.
The practice of accepting and giving interest has existed since
3000 BC, during the Sumerian civilization. During the Sumerian
period (3000 BC-1900BC) there was evidence of a systematic credit
system with loans using two standards of value, grain based on
quantity and silver based on weight. These loans contained elements
of interest; the interest rate was 33.33";. and 20".. per vear for wheat
loans and silver loans, respectively. During the Babylonian period
(1900 BC-732 BC). King Hammurabi issued a regulation (around
1800 BC) known as the Code of Hammurabi. Phis trecognized the
interest rate established during the Sumerian period and adopted
it as the legal rate. This rate was used for almost 1,200 years
(Homer, 1977).
This practice of taking interest continued through to the
Assyrian (732 BC-625 BC), Neo Babylonian (625 BC 539 BC).
Persian (539 BC-33.3 BC). Greek (500 BC-100 BC) and Roman
(500 BC-400 BCl periods. Christianity, during its early years, that
is, in the 3rd century, never condoned the practice of taking interest
by its followers. Although there was strong opposition from the
priests and their churches, merchants continued to practise it. There
is evidence to show that during the reigns of kings in the European
countries, loans issued were also based on interest (Homer, 1977).
 THE CONCEPTS Of INTEREST, VSC'RT AND RHLl 165

DEFINITIONS OF INTEREST, USURY AND RIBA

According to Kamus Dwibaliasa (1985), interest is money that has

to be paid or that is paid for the "use of money. This sum, which is
expressed as a percentage of money borrowed, is added to the loan.
Usury is the practice of lending money at an exorbitant or illegally
high interest rate. The Oxford Dictionary (1989, p. 1099) defined
interest as:

Money paidfor the use ofmoney lent (the principal), orforforbearance

of a debt, according to a fixed ratio (rate per cent).

This dictionary (p. 365) gives two definitions for usury, the first one
being:

Thefact or practice oflending money at interest; especially in later use,

the practice of charging, taking or contracting to receive, excessive or
illegal rates of interest for money on loan.

The second definition of usury according to this dictionary is:

Premium or interest on money (or goods) given or received on loan;

gain made by lending money.

The definitions given by Oxford Dictionary and Kamus Du’ibahasa

do not fit the meanings of interest and usury as held in the earlier
periods. The word "interest" originates from the language of the
mid-Latin period, that is, interesse, which means compensation for
loss, or payment of compensation (Barnhart Dictionary of Etymology,
1988). According to Divine (1959), in Roman law, interest, or in
Latin id quod interest, means compensation for damages or loss
suffered by the creditor resulting from the failure of the debtor to
settle the loan at the specified date set in the contract. Noonan (1957)
asserted that the Latin word intern means something that is lost. In
this case, interest does not mean a gain; instead it means a loss, that
is, compensation given to the creditor as a result of loss incurred
166 CHATTER 4

through lending. In other words, interest really means damages or

loss in a broad context, including possible loss of profit on the part
of the creditor through the money lent (Homer. 1977). The definition
of interest as loss to the creditor continued to be used until the
mediaeval period (the 12th and 13th centuries) (Divine, 1959).
The word "usury" originates from the Latin word usura, which
during the middle Latin period was referred to as usuria (Barnhart
Dictionary of Etymology, 1988). In the Greek language, usury is
termed tokos, meaning to "bring forth". Hence, when used in the
context of loans, usury is the price paid for the use of loan money In
a wider context, usury covers whatever charge or payment imposed
as a result of borrowing either goods or money, including what is
termed in Latin as mutuum. Mutuum is a loan of things meant for
immediate comsumption. It involves the transfer of possession and
right from lender to borrower. It can be in the form of food products
or money used to buy food, as well as loan of items to be used, such
as houses and equipment. Due to the fact that most Ioans are in
the form of money, usury therefore means the charge for the use of
money. The Christian religion actually strictly forbids its followers
from taking usury. But the word usury was rarely interpreted by the
Christian priests at that time even though it was generally regarded
to be present in loans. St. Ambrose (339-397), one of the early
Christian priests, regarded usury as whatever payment made that
exceeded the principal borrowed, where the item borrowed may
be in the form of money, food, clothing, equipment or other items.
St. Augustine (354-430), a contemporary of St. Ambrose, said:

The usurer is he who expects to receive more than he has given. whether
of money, or ofcorn, or of wine, or of oil, or of anything else.
(Divine, 1959, p. 30)

This means that St. Augustine defined usury as the sum received
by the creditor beyond the exact amount lent, where the additional
amount may be in the form of money, com. wine, oil or anything
else. The first definition of usury issued in the Middle Ages
 THE CONCEPTS OT INTEREST, CSURT AND RHEA 167

(1000-1500) by Pope Leo the Great (440-61) in his capitulary of

Nynweger of 806 was:

...where more is asked than is given. (Noonan, 1957, p. 15)

/
In other words, usury exists when a person asks for more than what
he has provided earlier. Fifth Lateran Council in the year 1515 gave
this definition of usury:

TWien gain is sought to be acquiredfrom the use ofa thing not fruitful
in itself, without labor, expense or risk on the part of the lender,
(Divine, 1959, p. 64)

Cardinal de Lugo (1593-1623), a Christian reformist, defined usury

as follows:

Usury is gain immediately arising as an obligation from a loan of

mutuum. ..if the gain does not arise from a mutuum but from purchase
and sale, however unjust, it is not usury; and likewise if it is not paid
as an obligation due but from goodwill, gratitude, or friendship, it is
not usury. (Dempsey, 1948, pp. 164-165)

Based on the definition provided by Fifth Lateran Council, usury is

the profit expected by the loan giver on the loan of an item which
does not by itself produce any return, while the loan giver in turn is
not involved in any effort or expenses and neither is he exposed to
any risk of loss. Meanwhile, de Lugo interpreted usury as emerging
from the process of borrowing and not from sale and purchase. The
trade and commercial revival in the 12th century intensified the
practice of borrowing or the practice of giving loans. As a result,
Christian scholars and theologians began to conduct discussions
on interest on an increasingly scientific basis. This period is better
known as the Age of Scholasticism (which spanned from the 12th
to the 16th century).
This philosophy was made the basis for discussion by 16th to
18th century reformists who recognized the right of the creditor to
receive returns from the money he had lent. The money or returns
168 chapter 4

from the borrower or debtor was not regarded as usury but instead
as excessive interest incurred on the loan. The meaning of the word
interest was given by the Christian Holy Office in the year 1836
when the office issued a public decree that allowed interest to be
taken by its followers. Interest is the price for the loan of money and
is regarded as the premium for the price of present money in terms
of future money (Divine, 1959). It is from this date that the word
"usury" is taken to mean excessive interest rate, while "interest" is
taken to mean the legal rate.
Modem economists have also offered other meanings to the
word "interest". Bohm-Bawerk (1851-1914), a famous Austrian
economist, described the origins of the word "interest" in his book
Capital arid Interest. Bohm-Bawerk believed in the influence of time
on the value of goods where the present value of the same item is
much higher compared to its value in the future.
The public, on the other hand, prefers present goods to future
goods. Nevertheless, there are people who are prepared to wait or
to postpone consumption and to put to use the goods at a later time.
This willingness to postpone consumption is called exchange value.
This value, according to Bohm-Bawerk. is the relationship between
the present and future goods, and is the root for the word "interest"
(Bohm-Bawerk, 1959). Fisher (1954), in his book The Theory of Interest,
defined interest as the percentage of premium charged on money at
a certain date in the form of money which is required to be repaid
within the next one year. Meanwhile, Keynes (1939) in his book The
General Theory ofEmployment, Interest and Money, defined interest rate
as a reward for willing to part with money or giving up liquidity.
Interest rate depends on the preference that people have about
holding onto money.
Riba is an Arabic word which literally means "increase"
(al-ziyada), "grow" (al-numuw), "to rise” and "to become lofty"
(al-irtifa and al-uluw) (Ahmad, 1992).IbnManzur(630H/1223-711 H/
1311 -2) in his book. Lissanul Arab, stated. "The root of it is the increase,
of the riba of money where it has increased" (Homoud, 1985).
 THE CONCERTS OF INTEREST, USURY AND RIB I 169

According to several ulama such as Al-Khatib Al-Sirbini and

Al-Ramli (Shafiis) and Ibn Abidin (Hanafis), an "increase" in the
number or amount is considered as riba. Meanwhile, the Hanbalis
have ruled that the word riba i$ restricted to increases in specific
goods only (Al-Zuhayli, 2003).
Al-Tabiri or al-Tabari (d. 310 H/923), an interpreter, was of the
view that the word riba is related to the word rabia or hill and it was
thus called because it was greater in height and overlooked the level
of the surrounding ground. The word riba can be applied in two
different contexts. First, it can mean an increase to the item itself,
and secondly, it can be an increase resulting from a comparison or a
differential between two items (Homoud, 1985).
The word riba was also used by the pre-Islamic Arabs. According
to them, riba was what they dealt in on the basis of increase of money
in consideration of extension of the terms of maturity, either from
the date of maturity or from the actual date of debt (Homoud, 1985).
Thus, in many instances, contemporary Muslim scholars often link
the word riba with loan, and use this pre-Islamic meaning in their
elaboration of the word riba.
Khan and Mirakhor (1987) defined riba as an addition to the
amount of the principal loan on the basis of time for which it is
loaned or of the time which the payment is deferred. Salleh (1986)
in his commentary on riba said:

Riba in its Syariah context, can be defined, as generally agreed, as

an unlawful gain derived from the quantitative inequality of the
countervalues in any transaction purporting to effect the exchange of
two or more species (anwa‘, singular naw'), which belong to the same
genus (fins) and arc governed by the same efficient cause Cilla, plural:
‘Hal). Deferred completion of the exchange of such species. or even
species which belong to different genera but are governed by the same
'ilia, is also riba, whether or not the deferment is accompanied by an
increase in any one of the exchanged countervalues.
(Saleh, 1986, p. 13)
170 CHATTER 4

CONCEPTS OF INTEREST AND USURY FROM

THE NON-MUSLIM PERSPECTIVE

Among the non-Muslims, too, there are varied views on interest

and usury. However, discussion in this book is limited to particular
groups only. The first group is the group in the pre-Christian
civilization, that is comprising the Jews, Creeks and Romans. The
second group comprises the Christians. There are three reasons
why these groups are chosen. First, Islam recognizes the prophets
of the Jews namely Abraham, Isaac, Moses, and the prophet for
the Christians. Jesus. The names of these prophets are frequently
mentioned in the Quran; for example, in Surah al-An aam, verses 84
and 85:

We gave him Isaac and Jacob: all (three) We guided: and before hint.
We guided Noah, and among his progeny, David, Solomon, lob, Joseph,
Moses, and Aaron: thus do We reward those who do good:

And Zakariyya and John, and Jesus and Elias: all in the ranks of the
Righteous: (Q6: 84 and 85)

Similarly in Surah al-Baqarah, verse 87, Allah (s.w.t.) says:

We gave Moses the Book and followed him up with a succession

of Messengers; We gave Jesus the son of Mary Clear (Signs) and
strengthened him with the holy spirit. Is it that whenever there comes
to you a Messenger with what you yourselves desire not, ye are puffed
up with pride? - some ye called imposters, and others ye slay!
(Q2:87)

Islam recognizes these two groups as "the people of the Book"

because the Jews have the book Taurat. and the Christians have
the book Injil. The Quran frequently refers to these people as "the
people of the Book" and there are many verses regarding them. For
example, Allah (s.w.t.) says in Surah al-Baqarah. verses 145 and 146:
 THE CONCEPTS OF INTEREST, USURl AND KIRI 171

Even if thou wert to bring to the people of the Book all the Signs
(together), they would not follow thy Qiblah, nor art thou going to
follow their Qiblah: nor indeed will they follow each other's Qiblah. If
thou after the knowledge hath reached thee, wert to follow their (vain)
desires - then wert thou indeed (clearly) in the wrong.

The people of the Book know this as they know their own sons: but
some of them conceal the truth which they themselves know.
(Q2: 145 and 146)

The second reason the Jews and Christians are chosen for
discussion is the relative abundance of literature by their great
priests on interest and usury. It is important to lend attention to
these writings, from which comparisons could be made with the
views of some Muslims who contend that interest is not forbidden
by Islam. Thirdly, the views of the Greeks and Romans also need to
be examined because of their contributions to human civilization.
Their views have exerted a great deal of influence on the thinking
of Muslims and non-Muslims on interest and usury.
In the following discussions, the word "interest" will be used
instead of usury. Before 1836, the word usury had the same meaning
as the word interest as used today, that is the sum in excess of the
principal amount of a loan. The definition of usury as exorbitant
or excessive interest was used after the Christian Church legalized
usury at a permissible rate, and this permissible rate was termed
"interest".
This does not, however, mean that other groups are not associated
with interest and usury. For instance, in Hinduism, references to
usury' are to be found in ancient Indian religious manuscripts, Vedic
(2000-1400SM) and Sutra (700-100SM). In the Vedic text, the usurer or
kusidin, that is the one who gives out interest-rate loans, is mentioned
several times. More detailed references to interest payment can be
found in the book, Sutra. Vasishtha, a well-known Hindu lawmaker
of that time, drew up a special law which forbade the highest castes,
Brahmanas and Kshatriyas from giving out loans based on interest. In
172 CHAITIUI 4

the Buddhist's holy book of Jakatas (600-400 SM), usury is referred

to in a demeaning manner (www.americanfinance.com). By the 2nd
century, usury had become a more relative term, as inferred in the
Laws ofMenu, which stated that any interest exceeding the legal rate,
which cannot be recovered is called usury-based loan (Jain, 1929).
The concept of usury among the Indian society eventually ceased to
be a topic of discussion. While it is still condemned, the practice of
usury is no longer prohibited or controlled in any substantial way.

The Concept of Interest Among the Jews

The Jews are also forbidden from taking interest. This prohibition is
found in two of their holy books, the Ibrani book and Talmud. This
book will only discuss the prohibitions found in the Ibnmi book.
Among the Jews, the Jbrani book is known as Tanak and among
the Christians it is known as the Ohl Testament (Gottwald, 1985).
The word Tanak is an abbreviation of the three parts of the book,
namely Torah (laws or Pentateuch), Nevi'im (prophets) and Kethuvim
(writing). The Ibrani Bible through verse 22: 25 in the chapter Exodus
and verses 25: 35-37 in the chapter Leviticus forbids the Jews from
taking interest through loans granted to the poor, and among Jews
or among strangers who have been accepted into their community.
Exodus 22: 25, states:

Ifyou lend money to one of my people among you who is needy, do not
be like a moneylender: charge him no interest. (Holy Bible, p. 58)

Leviticus 25:35-37, state:

If one of your countrymen becomes poor and is unable to support

himself among you, help him as you would an alien or a temporary
resident, so he can continue to live among you.

Do not take interest of any kind from him, but fear your God. so that
your countryman may continue to live among you.
 THE CONCEPTS or INTEREST, CSVRT AND UBA 173

You must not lend him money at interest or sell him food at profit.
(Holy Bible, p. 93)

The verses above require Jews not to demand more in return than
what they had lend. Seeking profit from the poor is not showing
charity or mercy but acting as an extortioner and oppressor,
devouring the needy borrower (Divine, 1959). The verses also show
that all kinds of interest, moderate or exorbitant, are forbidden and
regarded as a form of extortion. The Jews are forbidden from taking
interest not only from the poor, but also from those among them
regardless of financial position. However, the Jews are allowed to
take interest from foreigners from outside the Jewish community,
This is illustrated by the chapter Deuteronomy, verses 19 and 20.
Deuteronomy 23: 19-20, state:

Do not charge your brother interest, whether on money or food or

anything else that may earn interest.

You may charge a foreigner interest, but not a brother Israelite, so that
the LORD your God, may bless you in everything you put your hand
to in the land you are entering to possess. (Holy Bible, p. 147)

The group of the two verses above is a collection of verses which

clearly forbids the Jews from taking interest. In addition, there are
verses from other chapters in the Ibrani book which praise those
who abstain from taking interest and condemn those who do. There
are several other verses in the book which touch on this matter.
Among them:
Verse 18: 8 in chapter Ezekiel:

He does not lend at usury or take excessive interest. He withholds his

hand from doing wrong and judges fairly between man and man.

Verse 15: 5 in chapter Psalms:

Who lends his money withouI usury and does not accept a bribe against
the innocent. He who does these things will never be shaken.
174 CHAITI B 4

Verse 18:17 in chapter Ezekiel:

He withholds his hand from sin and takes no usury or excessive

interest. He keeps my laws and follows my decrees.

Verse 18:13 in chapter Ezekiel:

He lends at usury and takes excessive interest. Will such man live? He
will not.1 Because he has done all these detestable things, he will surely
be put to death and his blood will be on his own head.

The Concept of Interest Among the Greeks

and Romans
In contrast to the Jews who are forbidden from taking interest
through several verses in the Old Testament, there is no single
provision in the Grecian law that prohibits the taking of interest.
The Mesopotamian civilization considered the taking of interest as
legal; so too did tire Greeks and Romans.
During the Greek civilization (6 BC till AD 1) there were
several types of interest rates for loan repayment and investment
repayment. The interest rate was called the "customary interest
rate". The interest rate for loans was divided into interest for,
namely, normal loans (6%-18%), loans on real estate (6.67%-l 2"..),
loans to cities (7%—12%) and loans to industry and commerce
(12%-18%). Meanwhile, the interest rate for investment was the
rate paid to those who undertook particular investments (6%—10%)
(Homer, 1977). In the Roman civilization, payment of interest
began in 5 BC and ended in AD 4. The Law of Twelve Tables (450 BC)
was the first Roman law which permitted the taking of interest
within a graduated maximum legal rate Although the taking of
interest was allowed, the interest rate could not be compounded
(Thomas. 1976). During the period of Lex Genucia (342 BC). the
taking of interest was made illegal. However, the illegal status
was revoked during the period of Lex Unciaria (88 BC) and the
 THE CONCEPTS OF INTEREST, I'SURl AND Kill I 175

practice of maximum interest rate was reintroduced, There were

four types of interest rates during the Roman period, namely the
Roman maximum rate allowed (8.33%—12.5%), the normal interest
rate in Rome (4%—12.5%), provipcal interest rate (6%-100%) and
Byzantine interest rate (4%-12.5%) (Homer, 1977).
This practice of taking interest was, however, condemned
by Greek philosophers. Renowned Greek philosophers, Plato
(427 BC-347 BC) and Aristotle (384 BC-322 BC) condemned such
practice and abolished it from the communities that they established.
Similarly, the Roman philosophers such as Cato (234 BC-149 BC)
and Cicero (106 BC—13 BC) also condemned the practice of taking
interest by the Romans. While all these philosophers were quick
to disapprove the practice of taking interest, they failed to develop
philosophical bases for their objections. Apart from that, their
prohibition of interest raised doubts as to whether interest was
regarded as undesirable or because they disapproved of wealth
acquired through interest (Bohm-Bawerk, 1959).
Plato’s views on interest are found in two of his books, The Republic
and The Law. In The Republic, Plato contended that the insatiable
desire for wealth was destructive to the state. A government that
believed power depended on wealth and that it benefited from
the over-spending of squanderers, was likely to encourage their
extravagant behaviour, giving them loans at interest and acquiring
their properties in the event of default. Individuals who lost their
property this way would eventually rebel, become hateful and take
vengeance against those who had robbed them of their property.
Thus, Plato suggested that everyone should enter into a contract
voluntarily and at their own risk, thus reducing disgraceful
money-making practices. In The Law, Plato asserted that land be
made a public property but it should be apportioned to individuals
for private use. Furthermore, no opportunity should be presented
for people to make excessive money and facilities must not be
granted to malicious money-making business. The people may not
hold gold or silver except for daily exchange.
176 CHAPTER 4

Regarding loans, Plato was of the opinion that no one should

deposit his money with someone he did not trust and lend it at
interest. This is because should anything undesirable occur, the
debtor wasallowed to not pay back the principal money and interest.
Hence, Plato disapproved the creating of wealth by means of trade,
of borrowing and lending, and of possession of gold and silver. This
is because the fundamental purpose of laws of the state is for the
happiness of the people and unity for mutual benefit. Happiness
and goodness go hand in hand, but people cannot be both good
and exceedingly wealthy at the same time. Although interest was
prohibited at that time, if a person failed to fulfil the responsibility
agreed upon earlier, or failed to pay after using a service, then the
person was bound to pay a fine, where the fine imposed was in the
form of interest of 200% per annum (Divine, 1959).
Plato deplored interest on two counts. First, because interest
caused strife and feelings of dissension among people within the
same community, and secondly because interest was regarded as a
tool of exploitation of the poor by the rich. Aristotle was not only
in agreement with Plato, but in fact further regarded the concept
of interest as truly unjust since money obtained in this manner
was employed for a function different from what was originally
intended and thus, contrary to the natural purpose of money itself.
According to Aristotle, money was devised to facilitate exchange.
He condemned interest as the unnatural breeding of money by
money. Since interest (totes in the Greek language which means to
expand or produce) is money borne out of money and it is contrary
to mercy and humanity to demand interest from the poor and needy,
taking interest on money lent was considered the most unnatural
and unjust of all trade by Plato and Aristotle. The condemnation of
interest by these two Greek philosophers was based on the grounds
as summarized below:

(i)This type of money-making practice is regarded as a demeaning

profession, and it hampers the true economic enterprise
 rut CONCEITS Of INTEREST, USURY ANO KIR I 177

function, which is to satisfy wants rather than to seek profit.

This money-making method hinders people from carrying out
their main duty of practising righteousness.

(ii) The practise of taking interest by the rich is contrary to the

charity and benevolence that should be practised by them
towards the poor.

(iii) Interest has adverse effect on the welfare of the nation,

destroying peace and harmony because it tends to set one
class against another.

(iv) Interest, by its very nature, is a violation of justice.

As with the Greeks, the Roman philosophers were unanimous in

their condemnation of the practice of taking interest. The reasons
they presented were almost the same as those given by the Greeks.
Cicero, for instance, warned his son that the two occupations to be
avoided were collecting taxes and money lending. However, Cicero
did not completely reject the concept of interest; he agreed to the
taking of interest within reasonable bounds. Cato held the view that
it is at times more profitable to use money in trade or in lending.
Nevertheless, he forwarded two analogies for the two occupations
as follows:

(i) Trade is a very risky occupation while lending is

dishonourable.

(ii) His ancestors regarded the usurer as less desirable than a

thief; usurers were fined four times the amount taken whereas
robbers were penalized only twice the amount taken.

Tlie views presented by the Greek and Roman philosophers

who regarded interest as something low and offensive were also
ingrained in the public opinion at that time. These views can be
indubitably attributed to the presence of an unhealthy situation
associated not only with the practice of taking interest but with the
178 <H*riiK4

heavy debt burden contracted by the poor as a result of unwise use

of money.

The Concept of Interest Among Christians

Initially, Christians were forbidden from taking interest. While
the Jews are prohibited by the Old Testament from taking interest,
nowhere in the book of the Christians, the New Testament, do
we explicitly find direct evidence on the prohibition of interest.
However, some interpret verses 6: 34-35 in the chapter Luke as a
condemnation of the practice of taking interest, a practice which
extorted money from the public and did not bring any benefits (The
Catholic Encyclopedia, Vol. 15, 1912).
Luke 6: 34-35, state:

And if you lend to those from whom you expect repayment, what
credit is that to you? Even sinners lend to sinners, expecting to be
repaid in full.

But love your enemies, do good to them, and lend to them without
expecting to get anything back. Then your reward will be great, and
you will be sons of the Most High, because he is kind to the ungrateful
and wicked. (Holy Bible, p. 767)

Due to the absence of explicit prohibition, there emerged various

conceptions and interpretations by the Christian high priests,
intellectuals and scholars as to whether or not it was permissible for
Christians to charge or collect interest. This book will discuss the
conceptions of three major groups, namely the 1st to 12th century
Christian priests, the 12th to 16th century scholars and the 16th to
19th century reformists.
Each of these selected groups had differing views on interest
loans and the way in which these groups described and discussed
the concept of interest also differed. The first group prohibited
the taking of interest and made such practice illegal. The second
 rm concerts or interest, usury and r/ih 179

group wanted legalized interest to be permitted and the third

group legalized interest in Christianity. Soon after the Church
legalized the taking of interest in 1836, discussions on the legality
of interest discontinued. Nevertheless, certain groups still strived
to make it illegal. The last priest who wanted interest illegalized
was Father Jeremiah O'Callaghan (1780-1861), whose career began
in Ross Carberry (South Ireland) and ended in Vermont (United
States). However, Father O'Callaghan did not succeed in his efforts
and his fight was considered an individual battle since he did not
receive support from other Catholic missionaries or the Church
(Nelson, 1949).

Views of the Early Christian Priests

Early Christianity - 12th Century

Since there was no provision in the New Testament regarding the

taking of interest, the teachings and views on the prohibition
against lending on interest as found in the Old Testament were
taken as a guide in the early period of Christianity. The use of the
New Testament for reference on the practice of taking interest only
began around the year 1050 (Noonan. 1957). Most explanations
and declarations on usury and interest were delivered by priests
of Early Christianity in their homilies and sermons, in which they
explained the detriments associated with interest. They clarified
that involvement in the practice of lending money at interest was
evil and unworthy because it violated the teachings of Christianity
which stressed the quality of benevolence. The practice of taking
interest had emerged as a result of extreme greed in the hearts of
the usurers (Divine, 1959).
St. Basil (329-379), one of the priests of Early Christianity
regarded the sin of interest as an act of inhumanity- The lenders
procured profit from the adversities of the needy and accumulated
gold and wealth from the tears and hardship of the poor. He tried
180 chahmU

to coax the rich and the poor from engaging in loan transactions.
St. Gregory of Nyssa (335-395) condemned the practice of taking
interest on the grounds that the apparent kindness shown by the
creditor through rendering help in the form of a loan was actually
ingenuine, for the loans rendered to the poor would in reality
bring the poor to ruin. Those rendering the loans merely wished to
accumulate gold for themselves, without contributing any benefit
to others. St. Gregor}' also likened usury to attacks made on victims
who were already wounded. St. John Chrysostom (344-407) was
convinced that the prohibitions on the practice of taking interest
on loans found in the Old Testament for the Jews encompassed
the universal prohibitions in the New Testament. St. Ambrose
labelled the consumer of interest as a fraud and a traitor, and
also as tidal waves that caused shipwreck. St. Augustine asserted
that imposing interest on the poor was more cruel compared
with the crime of a robber who stole from the rich (Divine, 1959).
St. Anselm of Canterbury (1033-1109), a skilful Italian trader, was
the first person in the Middle Ages to equate the practice of taking
interest on loans with robbery (Noonan, 1957).
The opinions and views of the priests towards interest during
Early Christianity were reflected in several pieces of legislation,
known as Canon, formulated and implemented during that period.
Canon 20 which was issued by the Council of Elvira in Spain in
the year 306 was the first law passed prohibiting interest by all
clerics. Those found practising it would be demoted (The Catholic
Encyclopedia, 1912) However, the Canon did not clearly state
whether the prohibition also applied to laymen. Similarly with
Apostolic Canon no. 44 issued by the Council of Arles in the year
314 which forbade clerics, under penalty, from practising interest.
Canon 17 issued by the First Council of Nicaea in the year 325
threatened to dismiss clerics found to practise interest (Tanner,
1990). The prohibition was first extended to the public in Canon 12
by the Council of Carthage in the year 345 and Canon 36 by the
Council of Aix-la-Chapelle in the year 789.
 TH1 CONCEITS OF INTEREST, L'SURT AND KIB.t 181

The condemnation of interest by the Christian Church gained

momentum during the 9th century. All priests were required to
forbid Christians from taking interest and to punish those who
disobeyed. In fact, the Canon issped in the third conference of the
Council of I-ateran in the year 1179 denied Christian burial to all
manifest usurers. Tire Council of Lyons II in 1274 ordained that
no society, companies, organizations or individuals should allow
foreigners who practised interest to rent their houses. The peak of
the protest occurred in 1311 when the Council of Vienne declared
that civil laws had no influence, and those who did not consider
interest as sinful were regarded as people who had deviated from
the Christian faith (Hasting, 1921). The views of the priests of Early
Christianity may be summarized as such:

(i) Interest is anything asked for in return, which exceeds the

amount of the item lent or loaned out earlier.

(ii) The taking of interest is a sin and it is prohibited by the Old

Testament and the New Testament.

(iii) The hope or intention to receive returns which are more than
what has been loaned out is a sin.

(iv) Interest must be given back to the original owner.

(v) The high price of items for sale in the form of credit amounts
to interest which is hidden.

Views of Scholars
Twelfth Century - Sixteenth Century

Rapid development in the field of business and trade in the

early 12th century assigned a prominent role in the economy to
money and credit. Traders needed more money to finance their
trade; consequently, credit became one of the important sources
182 cH*n>.K-l

of financing at that time. When the amount of commercial loans

increased, the issue of taking interest on loans became a topic of
discussion. Two important elements were found in the nature of
lending during the 12th century- First, there were commercial loans
as well as consumption loans. Secondly, there was an inclination
towards the development of a money and capital market or the
establishment of the market interest rate (Divine, 1959). The fact that
commercial loans were different from consumption loans gave rise
to demands for the extension of the concept of interest. Discussions
were not merely from the moral perspective as deliberated by early
Christian teachings, but also involved the concept of debtor-creditor
relationship.
Prior to this, discussions on interest only revolved around
aspects of Christianity. The early priests mostly used verses found
in their holy books. They regarded the practice of taking interest
as inhumane, immoral, an exploitation of the poor and in conflict
with the teachings of Christianity. Very rarely did the discussions
revolve around economic or legal aspects. These priests were
the only ones to have gone to great lengths to discuss the issue
of interest, although they were not comprehensive in principle
(Bohn-Bewark, Vol. 1. 1959).
In their discussions on interest, the scholars, in addition to
moral issues extended their consideration to other aspects, such
as issues of types and forms of laws, individual rights on holding
property, characteristics and meaning of justice, forms of profit,
intentions of human actions and the difference between individual
and public sins with respect to interest (Noonan. 1957). This group
of scholars were seen as the pioneers who paved the wav for the
new interpretation of the word "interest". They eventually assigned
different meanings to the words "interest" and "usury". "Interest"
was regarded as interest rate which was valid or legal, while
"usury" was seen as excessive interest rate. In addition, this group
was also the most significant contributor in the re-elaboration of the
meaning of the word "interest". Robert of Courcon (1158-1218) and
 Illi CONCEPTS O1 INTEREST, VSlm AND Kill* 183

Willian of Auxxerre (1160-1220) were pioneer theologians in the

discussion of the concept of interest. Other priests who made major
contributions to the development of the concepts of interest and
usury were St. Raymond of Penpaforte (1180-1278), Alexander of
Hales (1168-1245), St. Albert the Great (1206-1280), St. Bonaventure
(1221-1274) and St. Thomas Aquinas (1225-1274). However, it is the
analysis on interest made by St. Thomas Aquinas which was said
to have a significant influence on subsequent scholastic theory on
interest.
The following are among the major issues concerning interest
which were resolved by the scholars: first, the intention or action
to acquire profit through lending was regarded as a sin and
injustice. Secondly, the taking of interest from a loan was permitted.
However, whether or not it was illegal depended on the intention
of the creditor. Interest was considered legal if the interest was paid
to the lender as compensation for granting a loan for benevolent
purposes. The scholars declared the rights of the creditor to seek
compensation in advance, but bad debt risks could not be used as
grounds for permitting the creditor to receive interest.

Views of Reformists
Sixteenth Century -1836

The era of the reformists began in the middle of the 16th century.
This group made changes and formed new perspectives on interest
and their views were somewhat different from those of the scholars.
Tire champion of this group was a Protestant leader named John
Calvin (1509-1564). His views were shared by two other famous
reformists, namely Charles Du Moulin (1500-1566), a French
Catholic lawyer and jurist, and Clude Saumaise (1588-1653).
Among other reformists involved were Martin Luther (1483-1546),
Melanchthon (1497-1560) from Germany and Zwingli (1484-1531)
from Switzerland.
184 CHAPTER 4

Calvin in his analysis on interest used what he called the Golden

Rule in which interest was redefined (Noonan, 1957). According to
him, interest was regarded a sin only when it harmed someone.
Calvin also rejected Aristotle’s view that money was sterile. Calvin
argued that money was something that multiplied. A person who
borrowed money would not leave it idle, but would instead use it to
add to his commodities and income. Although Calvin did not agree
to the prohibition of taking interest, neither did he agree with the
universal permissible interest. However, Calvin preferred interest
to be abolished completely. He felt that moderate interest might be
necessary for business, but the practice of taking interest must not
be made an occupation. Anyone making an income from lending
with interest should be expelled from the Church Interest must not
be taken from the poor and must not exceed the maximum legal
rate. Lenders should adhere to the words of God and not custom.
Taking interest was not considered a normal practice, and the lender
should not receive greater profit from the loans than the borrower.
The general concept of interest introduced by Calvin is that interest
is not a sin as long as it does not burden or hurt the debtor, and
interest is lawful on loans to the wealthy who borrow for the sheer
purpose of increasing their profits.
Charles Du Moulin (Molinaeus), a renowned French lawyer, was
the first Catholic writer to urge for the legitimateness of moderate
interest. According to Molinaeus, both the Old Testament and the
Neu' Testament prohibited the taking of interest by condemning it
as a sin against charity. He argued that the prohibition was only
directed towards the taking of interest from the poor, and nowhere
was it stated in the divine or natural law that lending money at
interest was prohibited. In the case of business loans, Molinaeus
stand was that it was unjust for the creditor to have a share in the
profit acquired by the debtor merely on grounds that he provided
the loan. Instead, Molinaeus stated that interest charged by the
creditor was charges tor the function of money which had a value.
 THE CONCI PTS Ol INTEREST, USURY AND KIB I 185

Hence, it was considered appropriate if payment were to be imposed

for that price.
Claude Saumaise(Salmasius), a follower of Calvin, was regarded
as the most outspoken leader in the defence of interest. While Calvin
was hesitant in allowing interest of any type, and Molinaeus was
against taking interest from the poor, Salmasius on the other hand
defended all moneylenders including those who made profits from
the poor. According to Salmasius, money could be sold just like any
other items in business. If it was legal for other businesses to buy
and sell goods with money, there should be no reason why making
money from money should be illegal. Given that even’ person
made his living from someone else, this rule was also applicable in
matters involving interest. Salmasius argued that the moneylenders
were actually providing a very useful service, that is fulfilling the
needs of society. Since the moneylenders were granted licence by
the government, this implied that they had been endorsed by the
government and thus were considered as government officials such
as tax collectors. In this case, if moneylenders were guilty of sin,
then the government was also guilty. Salmasius disregarded all
divine prohibition of interest. His inclination was towards secular
laws in managing interest and profit. In conclusion, the reformists
supported the full legitimization of interest on the basis that it did
not hurt or burden debtors. Instead, they believed interest help
businessmen by stimulating economic growth. Therefore, issues of
morality and impious were no longer of concern.

THE CONCEPT OF RIBA FROM THE

ISLAMIC PERSPECTIVE

In the past, there have been disputes among Muslim scholars as to

whether riba as spoken by the Muslims refers to the English term
186 CHAPTIR 4

"interest” or "usury". If we re-examine the meaning of the terms

"interest" and "usury" as held today, interest is money which is
paid at a fixed rate (usually in percentage form) against a particular
loan. Usury is the act of lending money at an exceedingly high
interest rate, and this rate is normally regarded as illegal by law.
Based on these definitions, there is clearly a major difference in
meaning between interest and usury. Tliis has led some scholars
to believe that what Islam forbids is usury and not interest. They
claimed that interest paid on loans for investment in productive
activities does not contravene the Quran for the Quran refers only
to usury on non-productive loans which prevailed in pre-Islamic
times when people were not familiar with productive loans and
their effects on economic development (Mannan, 1986).
There is a general consensus among Muslims scholars and
ulatlia that the word riba encompasses both interest and usury
(Khan and Mirakhor, 1987). This simply means that in Islam there
is no such thing as acceptable riba and extreme riba does not exist
from the legal perspective. Riba is considered riba regardless of
the amount involved. The Islamic Research College, University of
al-Azhar, Egypt at itssecond annual conference in 1965 had discussed
matters related to riba and banking operations. A resolution was
reached whereby it was determined that interest imposed by banks
on all types of loans constitutes riba, regardless of whether the loan
is for consumption or production or whether the amount involved
is big or small. All types of interest without exception is regarded
haram or unlawful (Homoud, 1985).

Prohibition Against Riba

Muslims are prohibited from dealing with riba. Ahmad (1992),

an Islamic scholar, asserted that there should not be two different
opinions on the categorical prohibition of riba in Islam. Differences,
however, lie in the interpretation of its scope and coverage.
 THE CONCEPTS Of INTEREST, USURY ANO Hlll.l 187

The prohibition of riba is not only revealed in various verses of the

Quran, but also in several Hadith. The Prophet Muhammad (p.b.u.h.)
clearly condemned the accepter and provider of riba.

Prohibition Against Riba by the Quran

The prohibition of riba in the Quran developed gradually and
appeared in' four revelations. The first revelation is in Surah
ar-Ruum, verse 39, the second in Surah an-Nisaa, verse 61, the
third in Surah Ali Imran, verses 131) to 132, and the fourth in Surah
al-Baqarah, verses 275 to 281.
In Surah ar-Ruum, verse 39, Allah (s.w.t.) says:

Thai which t/e lay out for increase through the property of (other)
people, will have no increase with Allah: but that which ye lay out for
charity, seeking the Countenance of Allah, (will increase): it is these
who will get a recompense multiplied. (Q30: 39)

The first revelation occurred in Mecca at the time when the city was
prosperous with business and trade. Traders were not only actively
involved in imports and exports and facilitated the transit of goods,
but they also participated in loans for interest, speculations and
aleatory transactions. These activities were performed because
of the traders' unwillingness to see their capital lying idle while
waiting for the arrival or departure of laden caravans. This
situation whereby traders involved themselves in riba was said to
be the reason for the verse concerned to be revealed to the Prophet
(p.b.u.h.) by Allah (s.w.t.) (Saleh, 1986).
The above verse strongly prohibits Muslims from taking riba.
The principle is that any profit Muslims seek to gain should be
through their own exertion and not through exploitation of other
people. Muslims must show their love for their neighbours by
spending their own resources or by the utilization of their own
talents and opportunities in the service of those who need them.
188 CHATTER 4

The reward will not be merely what they deserve but it will be
multiplied many times (Ali. 1989).
Further, Allah (s.w.t.) says:

That they took interest, though they were forbidden: and that they
devoured men's substance wrongfully - We have prepared for those
among them who reject Faith a grievous punishment. (Q4:161)

The second verse on riba which was sent down by Allah (s.w.t.) in
Medina has created some misunderstanding among intellectuals as
to whether the prohibition is directed at Muslims or at the Jews.
Hitti (1970), a renowned historian of Islam was of the view that the
prohibition is meant for the Jews in Medina. His view was based on
Allah's (s.w.t.) words in verse 160:

For the iniquity ofthe lews We made unlawfulfor them certain (foods)
good and wholesome which had been lawful for them - in that they
hindered many from Allah's Way. (Q4:160)

However, Saleh (1986) disagreed with Hitti's opinion. He refuted

it on two grounds. First, the practice of riba occurred while the
Prophet (p.b.u.h.) was still in Mecca, where there were few Jews at
that time. Secondly, the Jews in Medina in those times were mostly
involved in the agricultural sector and not in the commercial sector
According to Saleh, those involved in riba comprised the Muhajirun
(Meccans who accompanied the Prophet (p.b.u.h.) in his migration
to Medina) and the Ansar (Medinan Muslims) who dealt with
usury in Medina. To support his view, Saleh used the following
two statements issued by Abu Hurairah (19 SH/600-59 H'678) and
Abdullah Ibn Salam (d. 43 H/663-4), Companions of the Prophet
(p.b.u.h.).
In Sahih Bukhari’s collection of lladith, Abu Hurairah said:

You people say that Aim Hurairah tells many narrations from Allah's
Apostle and you also wonder why the emigrants and Ansar do not
narrate from Allah’s Apostle as Abu Hurairah does. My emigrant
 THE CONCI PIS OF INTEREST, VSim AND RIH I 1S9

brothers were busy in the market while I used to stick to Allah's Apostle
content with what fills my stomach; so I used to be present when they
toere absent and I used to remember when they used to forget, and my
Ansar brothers used to be busy tyilh their properties and 1 was one of
the poor men of Suffa. I used to remember the narrations when they
used to forget. (Khan, 1986, p. 149)

Abdullah Ibn Salam was reported to have said that the practice
of riba was widespread in Medina, which was considered to have
occurred after the death of the Prophet (p.b.u.h.) and after the Jews
were banished from Medina (Saleh, 1986).

Surah Ali Imran, verses 130-132, state:

O ye who believe! Devour not interest, doubled and multiplied; but

fear Allah; that ye may (really) prosper.

Fear the Fire, which is prepared for those who reject Faith:

And obey Allah and the Messenger; That ye may obtain mercy.
(Q3:130-132)

The above prohibition was sent down by Allah (s.w.t.) in the

wake of the Battle of Uhud, in the third Hijrah year. Al-Fahkr
ar-Razi (543 H/l 149-606 H/1209) believed there were two possible
reasons for the revelation of this verse. First, this verse may have
an association with the proceeding verse, where it is stated that
the Musyrikin had spent money on the troops who participated
in the battle, for which the money had been raised through riba.
Another possibility for the practice of riba by Muslims at that time
was to raise money to finance the battle against the Musyrikin
(Homoud, 1985).
The above verse shows that the prohibition is for all kinds of
riba. The words "doubled" and "multiplied" in the verse, however,
have created some anomalies among Muslim jurists and scholars.
Some interpreted it to mean that it only refers to riba which is
doubled and multiplied. Nevertheless, the majority of renowned
190 CHATTtK 4

scholars have made the resolution that the amount of riba has no
role in determining whether or not it is haram (unlawful by religion,
and sinful).
Qutub (1979) in his book. In the Shades of the Quran, expressed
the view that the terms used are no more than a state of affairs
and not a condition relevant to the imposition. Meanwhile, Syeikh
Muhammad Abduh (1849-1905), a famous ulama in Egypt was
reported to have said that it is not a condition of usury that the
capital sum must multiply so as to render the 100 to become
200, but usury (which originally means "increase") multiplies by
repetition. Shaltut (1974) also commented on the view that only
excessive riba is forbidden by the Quran. To him, the term "multiple
of multiples" was used by Allah (s.w.t.) to emphasize and condemn
the wrongdoings. Homoud (1985) explained that the riba which
existed in the pre-Islamic era was not about the 100 becoming 200,
but rather the multiplicity' of ages of the camels lent
In Surah al-Baqaralt, verses 275-281, Allah (s.w.t.) says:

Those who devour interest will not stand except as stands one whom
the Evil One by his touch hath driven to madness. That is because
they say: "Trade is like usury", but Allah hath permitted trade and
forbidden usury. Those who, after receiving direction from their Lord,
desist, shall be pardonedfor the past; their case is for Allah (to judge);
but those who repeat (the offence) are Companions of the Fire: they
will abide therein (forever).

Allah will deprive usury of all growth, but will give increase for deeds
of charity: for He loveth not creatures ungrateful and wicked.

Those who believe, and do deeds ofrighteousness. and establish regular

prayers and regular charity, will have their reward with their Lord: on
them shall be nofear, nor shall they grieve.

O ye who believe! Fear Allah, and give up what remains of your

demand for usury, ifye are indeed believers.
 tilt con< i ns or interest, uslrv ano hihi 191

If ye do it not. take notice of war from Allah and His Messenger: but
ifye turn back, ye shall have your capital sums: deal not unjustly, and
ye shall not be dealt with unjustly.

If flic debtor is in a difficulty, grant him lime till it is easy for him to
repay. But if ye. remit it by way of charity, that is best for you if ye
only knew.

And fear the Day when ye shall be brought back to Allah. Then
shall every soul be paid what it earned, and none shall be dealt with
unjustly. (Q2: 275-281)

The above verses were sent down in Thaif at the time when the
mission of the Prophet (p.b.u.h.) was almost complete. The verses
very strongly condemn the practice of riba. In verse 275, Allah (s.w.t.)
clearly mentioned that there is a difference between trade and riba.
While trade is permissible, riba is forbidden. The word "stand" in
this verse has two meanings. Some Islamic scholars interpreted it to
mean the conditions of those who take riba on the Day of Judgement.
Others were of the opinion that it describes the conditions of those
who associated themselves with riba; this attitude would cause
disruption in life.
Surah al-Baqarali, verses 276 and 277 elaborate upon the idea
that Allah (s.w.t.) will not bless those who take riba and will destroy
property which has the element of riba. In this case, the destruction
of property may be in this world or in the I lereafter. Similarly, those
who take riba will be punished in both worlds. In the subsequent
verses, there is a reminder that Muslims must fear Allah (s.w.t.) and
abandon the remnants of riba that occurred during the pre-Islamic
days. The inability to comply with this instruction will bring war
from Allah (s.w.t.) and the Prophet (p.b.u.h.).
This statement serves as a serious warning to Muslims that
they should not associate themselves with riba. They are allowed
to demand only the principal amount from the borrowers and they
are urged to deal justly and fairly with debtors. In the event that
192 CHAPTER 4

the debtor is unable to pay his debt, the lender has two alternatives.
The lender can either extend the repayment or to convert the loan
to charity. Of the two choices, verse 280 suggests that the second
is better for Muslims. The main point is that whoever transgresses
Allah's (s.w.t.) commands will be punished in this world through
disruption and failure in this life and also in the Hereafter. This fact
is found in verse 72 of Surah al-Isra', which states:

Bill those who were blind in this world, will be blind in the Hereafter,
and most astrayfrom the Path. (Q17: 72)

Prohibition Against Riba by the Hadith

In line with its function as the original and eternal source of Syariah
law, the Quran neither defines riba nor provides any detailed
explanation of riba (Ahmad, 1992). The prohibition of riba is revealed
in four chapters of the Quran which serves as a universal and
fundamental guideline for Muslims. Hadith, on the other hand, is a
source of reference which enables Muslims to confirm or to acquire
further explanation on the rules stipulated in the Quran. The Hadith
reports prohibition of riba in numerous accounts. Sometimes there
arc slight differences among the narrators. Hadith related to riba can
be classified into three areas, namely directive Hadith, explanatory
Hadith and reminder Hadif/i. Directive Hadith is Hadith that prevents
Muslims from dealing in any kind of riba. Explanatory Hadith is
Hadith that explains the types of riba and the circumstances of trade
that generate riba. Reminder Hadith is a Hadith that visualizes the
consequences for those who associate themselves with riba. This
classification is however not absolute. There is a possibility that
some Hadith belong to more than one classification. For instance, the
Hadith which says, "Gold for gold, silver for silver..." is suitable for
both the directive and explanatory categories. Some of the Hadith
related to riba are given on the next page.
 THE CONCEPTS OF INTEREST, USERS AND RUM 193

Directive Hadith

(i) "if they accept, mil and good and, failing which, warn them of war."
This Hadith was taken from Jhe the Prophet's (p.b.u.h.) letter
to Itab bin Osaid, the governor of Mecca, when the Thaqeef
claimed their debts from Bani Mogheera (Homoud, 1985,
p. 80).

(ii) O People,-just as you regard this month, this day and this city as
Sacred, so regard the life and property of every Muslim ns a sacred
trust. Return the goods as entrusted to you to their rightful owner.
Hurt no one so that no one may hurt you. Remember that you will
indeed meet your Lord, and that He will indeed reckon your deeds.
Allah has forbidden you to take riba, therefore all riba obligations
shall henceworth be waived. Your capital, however, is yours to keep.
You will neither inflict nor suffer inequality. Allah has judged that
there shall be no riba and that all riba due to Abbas ibn' Abd al
Muttalib shall henceforth be waived.
This Hadith is the last sermon delivered by the Prophet
(p.b.u.h.) on the Ninth Day of Dzul Hijjah 10 AH (after Hijrah)
(Chapra, 1992, p. 380).
(iii) Narrated by 'Aun bin Abu Juhaifa:

My father bought a slave who practised the profession of cupping.

My father broke the slave's instruments of cupping. I asked my
father why he had done so. He replied, "The Prophet (p.b.u.h.)
forbade the acceptance of the price of a dog or blood, and also
forbade the profession of tattooing, getting tattooed and receiving
or giving riba (usury), and cursed the picture-makers."
(Khan, 1989, p. 169)

(iv) Narrated by Abu Said Al-Khudri and Abu Hurairah:

Allah's Apostle (p.b.u.h.) appointed somebody as a governor of
Khaibar. That governor brought Io him an excellent kind of dales
194 <H*i,rt«4

(from Khaibar). The Prophet (p.b.u.h.) asked, "Are all the dates of
Khaibar like this?" He replied. “By Allah, no, O Allah's Apostle!
But we barter one Sa of this (type of dates) for two Sas of dates of
ours and two Sas of it for three ofours." Allah's Apostle (p.b.u.h.)
said, "Do not do so (as that is a kind of usury) but sell the mixed
dates (of inferior quality)for money, and then buy good dates with
that money." (Khan, 1989, p. 222)

Explanatory Hadith

(i) Narrated by Ibn Shihab:

Malik bin Aus said, "I was in need of change for one hundred
Dinars. Talha bin ‘Ubaid-UHah called me and we discussed the
matter, and he agreed to change (my Dinars I. He took the gold
pieces in his hands and fidgeted with them, and then said. Wait
till my storekeeper comes from the forest.' Umar was listening to
that and said, 'By Allah! You should not separate from Talha till
you get the money from him, for Allah's Apostle (p.b.u.h.) said.
The selling ofgold for gold is Riba (usury) except if the exchange
is from hand to hand and equal in amount, and similarly, the
selling of wheat for wheat is Riba (usury) unless it is from hand
Io hand and equal in amount, and the selling of barley for barley
is usury unless it is from hand to hand and equal in amount, and
dates for dates is usury unless it is from hand to hand and equal
in amount'.'"
(Sidiqi, undated, p. 833)

(ii) Narrated by Ibn‘Umar:

The Prophet (p.b.u.h.) said, "The selling of wheat for wheat is

Riba i usury) exeq't if it is handed from hand to hand and equal in
amount. Similarly the selling of barley for barley is Riba except if
 Tilt CONCEPTS OF INTEREST, USURY ANO KillI 195

if is from hand to hand and equal in amount, and dates for dates is
usury except if it is from hand to hand and equal in amount."
(Khan, 1986, p. 210)
(iii) Narrated by Abu Said Al-Khtidri:

Allah's Apostle (p.b.u.h.) said, "Do not sell gold for gold unless
equivalent in weight, and do not sell less amountforgreater amount
or vice versa: and do not sell silver for silver unless equivalent in
weight, and do not sell less amountfor greater amount or vice versa
and do not sell gold or silver that is not present al the moment of
exchangefor gold or silver that is present."
(Khan, 1986, pp. 212-213)

(iv) Narrated by Abu Salih Az-Zaiyat:

I heard Abu Said Al-Khudri saying: “The selling of a Dinar for a

Dinar, and a Dirham for a Dirham (is permissible)." I said to him,
"Ibn 'Abbas does not say the same." Abu Said replied, "/ asked
Ibn 'Abbas whether he had heard it from the Prophet (p.b.u.h.) or
seen it in the Holy Book. Ibn 'Abbas replied, 'I do not claim that,
and you know Allah’s Apostle (p.b.u.h.) better than I, but Usama
informed me that the Prophet (p.b.u.h. ) had said, 'There is no riba
(in money exchange) except when it is not donefrom hand tohand
(i.e, when there is delay in payment)'.'" (Khan, 1986, p. 213)

(v) Narrated by Abu Said al-Khudri:

Once Bilal brought Barni (i.e. a kind of dates) to the Prophet

(p.b.u.h.) and the Prophet (p.b.u.h.) asked him, "From where have
you brought these?" Bilal replied, "I had some inferior dates and
exchanged two Sas of it for one Sa of Barni dates in order to give it
to the Prophet (p.b.u.h.) to eat." Thereupon the Prophet (p.b.u.h.)
said. “Beware! Beware! This is definitely riba! This is definitely
riba! Don't do so, but ifyou want to buy (a superior kind ofdates)
sell the inferior dates for money and then buy the superior kind of
dates with that money." (Klian, 1986, p. 291)
196 r HATTER 4

(vi) Narrated by Abu Bakra:

Allah's Apostle (p.b.u.h.) said. "Don't sell gold for gold unless
equal in weight, nor silver for silver unless equal in weight, but
you could sell goldfor silver or stiverfor gold as you like."
(Khan, 1986, p. 214)

(vii) 'Ubada ibn al-Samit reported:

Allah's Messenger (p.b.u.h.) as saying, Gold is to be paid for by

gold, silver by silver, wheat by wheat, barley by barley, dates by
dates, and salt by salt, like for like and equal for equal, payment
being made hand to hand. If these classes differ, then sell as you
wish ifpayment is made hand to hand.
(Sidiqi, undated, p. 834)

(viii)Abu Sa'id al-Khudri reported:

Allah's Messenger (p.b.u.h.) as saying, "Gold is to be paid for by

gold, silver by silver, wheat by wheat, barley by barley, dates by
dates, salt by salt, like by like, payment being made hand to hand.
He who made an addition to it, or asked for an addition, in tact
dealt in usury. The receiver and the giver are equally guilty "
(Sidiqi, undated, p. 834)

(ix) Abu Hurairah reported:

Allah's Messenger (p.b.u.h.) as saying. “Gold is to be paidfor by

gold with equal weight, like for like, and silver is to be paid for by
silver with equal weight, likefor like. He who made an addition to
it or demanded an addition dealt in usury."
(Sidiqi, undated, p. 834)

(x) Abu Minhal reported:

“My partner sold silver to be paid in the (Haji) season or (in the
days of) Hajj. He (my partner) came to me and informed me,
and I said Io him: Such transaction is not desirable". He said:
 THE CONCEPTS OF INTEREST, USVK» ANO Kill t 197

'1 sold it in the market (on loan) hut nobody objected Io Ibis'. I
went to al-Bara' b. 'Azib and asked him. and he said: 'Allah's
Apostle (p.b.u.h.) came to Medina and we made such transaction,
whereupon he said: 'In case tlje payment is made on the spot, there
is no harm in it, and in case (it is sold) on loan, it is usury'. You'd
better go to Zaid b. Arqam, for he is a greater trader than T; so I
went to him and asked him, and he said the same."
(Sidiqi, undated, p. 835)

Reminder Hadith
(i) Narrated by Samura bin Jundab:

77ie Prophet (p.b.u.h.) said, "This night I dreamt that two men
came and took me to a Holy land whence we proceeded on till we
reached a river of blood, where a man was standing, and on its
bank was standing another man with stones in his hands. The man
in the middle of the river tried to come out, but the other threw a
stone in his month and forced him to go back to his original place.
So, whenever he tried to come out. the other man would throw a
stone in his mouth and force him to go back to his former place.
I asked, 'Who is this?' I was told, ‘The person in the river was a
riba-eater.
(Khan, 1986, pp. 168-169)

(ii) 'Abdullah b. Mas ud said that Allah’s Messenger (p.b.u.h.) cursed

the one who accepted interest and the one who paid it. I asked about
the one who recorded it, and two witnesses to it. He (the narrator)
said: "We narrate what we have heard."
(Sidiqi, undated, p. 839)

(iii) Jabir said that Allah's Messenger (p.b.u.h.) cursed the accepter
of interest and its payer, and the one who records it. and the two
witnesses, and he said: “They are all equal."
(Sidiqi, undated, p. 839)
198 CHATTKK 4

(iv) Narrated by Abu Hurairah:

Allah's Messenger (p.b.u.h.) said. "On the night of Ascension I

came upon people whose stomachs were like houses with snakes
visible from the outside. I asked Gabriel who they were. He replied
that they were people who had received interest. "
(Chapra, 1992, p. 381)

(v) Narrated by Abdullah ibn Hanzalah:

Allah's Messenger (p.b.u.h.) said, "A Dirham of riba which a man

receives knowingly is worse than committing adultery thirty six
times."

(vi) Narrated by Abu Hurairah:

Allah's Messenger (p.b.u.h.) said, "Allah would be justified in not

allowing four persons to enter heaven or to taste its blessings: he
who drinks habitually, he who takes riba, he who usurps orphan's
property without right, and he who is undutiful to his parents."
(Chapra. 1992, p. 383)

(vii) Narrated by Abu Hurairah:

Allah's Messenger (p.b.u.h.) said. "Riba has seventy segments the

least serious being equivalent to a man committing adultery with
his own mother." (Chapra. 1992, p. 381)

(viii) Narrated by Abu Hurairah:

The Prophet (p.b.u.h.) said, "There will certainly come a time for
mankind when everyone will take riba and ifhe does not do so, its
dust will reach him." (Chapra. 1992, p. 381)

Classification of Ribo

There is no standardization among the earlier and contemporary

Muslim scholars in classifying riba. The method of classification can
 THE CONCEITS Of INTEREST, USUKT ANO Him 199

be divided based on time, origin or source of prohibitions and the

nature of transactions that generate riba.
The first classification of riba is termed pre-Islamic riba. This
terminology is often used by tlje majority of past and present
Muslim scholars and jurists in explaining the riba which was in
existence prior to the introduction of Islam to Arabs. Pre-Islamic
riba is also known as Riba al-)ahiliyyah among certain Muslim
writers. Riba al-Jahiliyyah refers to the practice of increasing the
amount of debt as a result of extension of the term of maturity,
either from the date of maturity or from the actual date of debt
According to Homoud (1985), al-Tabiri in his interpretation of riba
which is forbidden by Allah (s.w.t.) stated that, "In the pre-Islamic
times when a man is indebted to another he used to say: '1 give
you so much if you extend the date for payment.'" With that, the
creditor would extend the date of payment. Al-Fahkr ar-Razi, in
his deliberation about the business practices of pre-Islamic Arabs
believed that Arabs with debt used to pay money monthly' and
left the principal intact. On maturity, the debtor had to pay the
principal amount. In the case of inability or failure to repay, there
was the possibility that the creditor would increase the amount of
principal and extend the repayment term. This additional amount,
according to ar-Razi, is called Riba al-]ahiliyyah (Homoud, 1985).
Besides the above classification, another type of riba is classified
based on the prohibitions of die Prophet (p.b.u.h.). Abu Zahra (1955)
in his book, Khalem An-Nabiyayn classified riba into two groups. The
first is called debt riba. In this situation, when money is loaned as
debt, the principal would increase each time the repayment date
is extended. The surplus or additional payment is regarded as
payment in return for the extended repayment date; this additional
payment is termed riba. In the second classification, the riba is called
sales riba, which according to Abu Zahra, is known as such because
the Prophet (p.b.u.h.) called it riba (Homoud, 1985), Similarly with
al-Jassas (1927) in The Rules ofal-Quran, who described the sales riba
which was unknown in the pre-Islamic period. Sales riba is divided
200 CHATTER 4

into two categories, increased riba and delayed payment riba.

Increased riba occurs when an item which is subject to riba is sold
with an addition of one consideration over the other. The delayed
payment riba, on the other hand, may occur in case of the sale of
an item subjected to riba for an item of its kind. Riba is committed
if the payment of either consideration is delayed (Homoud, 1985).
Pre-Islamic riba is also called Riba al-Quran, while sales riba is called
Riba al-Sunnah.
Ismail (1992) referred to the works of al-Arabi, al-Qurtubi
and al-Jassas in his discussion on deferred contract of exchange
mentioned in the Quran. He concluded that the word riba as
unanimously agreed by all three exegetists is known as Riba
al-Duyiin. This riba can be further divided into two components,
Riba al-)ahiliyyah and Riba al-Qardah. According to Ismail, Riba
al/ahiliyyah arises when the creditor in any deferred contract of
exchange, either in al-bai bithaman ajil (deferred sale), bai al-isfisna
(sale on order) or al-Ijarah (leasing), demands from the debtor an
amount over and above which was initially agreed tointheoriginal
contract. Riba al-Qardah is a similar additional consideration of
time, except that it is not an inducement for extending the period
of liability arising from a contract of exchange, but rather the
period of liability of a straight loan.
Al-Tabiri also believed that the prohibition against riba in
the Quran in verse 130 of Surah AH Imran refers to the riba which
occurred during pre-Islamic period. This riba covered the practice of
deferring debt with additional condition of an increase in the amount
of repayment. Ahmad (1992) when commenting on al-Tabiri's view
believed that the practice of increasing the amount of debt due to
an extension in maturity is also known as daun mu'ajjal. He further
argued that al-Tabiri's view created an ambiguity in two areas. First,
it is unclear whether dayn mu'ajjal emerged from sale transactions
or from loan dealings. Secondly, whether the stipulation of riba
occurred in the first term or during subsequent terms. Ahmad (1992)
concluded that dayn mu'ajjal mostly originated from the practice of
 TltT CONCEITS OF INTEREST, USURY AND KIIM 201

bay' bi'I-nasiah, which is credit sale with a fixed term (trade credit)
to the agreed price. This usually results in riba dealings which cause
the multiplication of the debt. Ibn al-Qayim (1292-1350) also classed
riba into two groups, namely overt riba and covert ribs. Overt riba
is, according to Ibn al-Qayim. deferred payment riba which was
practised during the pre-Islamic period while covert riba is the
increased riba, forbidden by the Prophet (p.b.u.h.) (Homoud, 1985).
However, these classifications are seldom used by other Muslim
scholars.
Modem Muslim scholars and jurists prefer to use Arabic
terminologies in elaborating riba. The terms frequently used are
Riba al-Nasiah and Riba al-Fadl. The word nasiah comes from the root
nasa'a which means "to postpone, defer or wait". It refers to the time
that is allowed for the debtor to repay the Ioan after its due date. In
return, the debtor must pay an additional amount or premium on
the extended paying period. This additional amount is considered
riba in Islam. Thus. Riba al-Nasiah is riba which had existed since the
pre-lslamic period anil which is forbidden by the Quran. In other
words, this riba is the same as Riba al-lahiliyyah. Since its prohibition
is mentioned in the Quran, some writers refer to it as Riba al-Quran.
This is also the riba which was mentioned by the Prophet (p.b.u.h.)
in the Hadilh narrated by Usama Ibn Zaid which means: "There is
no riba except in nasiah" (Chapra, 1992, p. 35). Riba al-Nasiah is also
sometimes referred to as Riba al-Duyun, Riba al-Mubashir and Riba
al-Jali.
Riba al-Fadl is riba which occurs as a result of trade or sale
transactions. It covers all on-the-spot transactions involving cash
payment and immediate delivery of goods. The prohibition of this
kind of riba is based on the Hadith that says: "Gold for gold, silver
for silver...." Thus, this riba is what Muslim scholars have termed
as sales riba and Riba al-Sunnah. It is also sometimes known as Riba
al-Buyu, Riba Ghyr al-Mubashir and Riba al-Khafi (Chapra. 1992).
Homoud (1985) subsequently divided this sales riba into two types,
increased riba and delayed payment riba.
202 CHAmn4

This classification of riba may be seen from various perspectives.

First, it may be seen in terms of time occurrence; secondly, from
the source of the prohibition, whether the Quran or Hadith; and
thirdly, the nature of transaction that can generate riba, that is,
whether loan or sale, or whether spot or deferred. Table 4-1 shows
the classification of riba based on time, that is pre-Islamic riba and
post-Islamic riba.
TABLE 4-1 Classificotion of Riba
Pre-lslamic Riba Post-lslainic Riba
Time of Before the After Islam became
Occurrence establishment of established
Islam
Source of al-Quran Hadith
Prohibition
Area of Extension of debt Point of sales:
Emergence - increment
- deferred
Common Debt riba Sales riba
Terminology Riba al-Quran Riba al-Hadith
Riba al-lahiliyyah Riba al-Sunnah
Riba al-Nasiah Riba al-Fadl
Riba al-Duyun Riba al-Buyu
Riba al-Mubashir Riba Ghyr al-Mubashir
Riba al-Jali Riba al-Khafi

Based on the classification in Table 4-1. it may be concluded that

pre-Islamic riba is riba resulting from the extension of debt. The debt
could either be from business transactions or a straight loan. Post-
Islamic riba, on the other hand, is riba originated from sales, and
may be further classed into increased riba or riba which occurs due
to unequal exchange value, and delayed payment riba or riba which
emerges due to increase in price or exchange value as a result of
extension of the payment period.
 the concepts or interest, vsvrt and kiva 203

An important criteria which differentiates prc-Islamic riba

and post-Islamic riba is the additional prohibition imposed
associated with the sale of business goods. Debt riba which was
known to the pre-lslamic Arabs jtas not necessarily ceased to exist
in the post-lslamic period. For instance, riba of a direct loan is
considered pre-lslamic riba even though the time of occurrence
is the post-lslamic period. Nevertheless, the majority of writers
nowadays prefer to use the terms Riba al-Nasiah (debt riba} and
Riba al-Fadl (increased riba) in their writings. In Islamic banking
system, the riba normally being discussed is debt riba or Riba
al-Nasiah. Hence, the interest imposed by conventional banks is
grouped as Riba al-Nasiah.
Apart from the various types of riba mentioned, there is one
more type of riba discussed by the ulama of Shafiis called Riba al- Yad.
Illis type of riba comes into effect when different goods of the same
group (such as wheat with barley) are traded with deferment on
the exchange period or without mentioning the term of deferment.
The Hanafiis, nevertheless, categorize this type of riba as Riba
al-Nasiah (Al-Zuhavli, 2003).

Riba Among Muslims

Unlike the Christians who were engaged in a long debate on the
legality of taking interest, Muslims were not involved in such a
debate. There are several possible reasons for this. First, the Quran
has given clear guidelines on the prohibition of riba. Secondly,
the Muslims during the early days, had the opportunity to obtain
clarification and guidance on this matter from the Prophet (p.b.u.h.).
This was made even easier by the fact that the Prophet (p.b.u.h.)
was Himself someone who possessed understanding and skills of
the methods of business. The explanation and guidance are found
in the Haiiith related to riba. In addition, the caliphs (successors of
the Prophet (p.b.u.h.)) also commented on the matter of riba. For
204 CHATTFK 4

example, Umar did not accept a gift of dates from a debtor, and he
explained that such practice was considered riba (Homoud, 1985).
In view of such instance, there is little controversy with regard
to the concept and doctrines of riba among Muslims. However, there
was some confusion among the early Muslims regarding sales riba
on one occasion. Tire account was written by As-Sarkhassi in his
book Al Mabsut. He reported Ibn Abbas and Abu Said al-Khudri
had some misunderstanding about sales riba. Abu Said warned Ibn
Abbas by saying:

"Oh ye H'ii Abbas, until when would you let people eat usury; did you
accompany God's Messenger, God's prayer and peace be upon him. as
no one else did; did you hear from him what was not heard by any one
else?" Ibn Abbas retorted. “No, but Ussama ben ZAYD related to me
that the Prophet, God’s prayer and peace be upon him. said, ‘There is
no usury except in delayed payment'," then Abu Sa'id said: "By God
1 will not stay with you under the same roof so long as you persist in
this say." (Homoud, 1985, p. 82).

Although the discussion on riba among Muslims has yet to reach

a final conclusion, this does not mean that ribo is a less significant
matter among Muslims. On the contrary, jurists of all four Muslim
mazaahib of Hanafi, Maliki, Shafii and Hanbali, have discussed and
issued specific guidelines on riba to be followed by Muslims. There
are some differences of opinion among the mazhab with regard to the
scope of the ban on riba, the transactions that constitute riba and the
types of properties subjected to riba. Modem Muslim scholars are not
left behind in the discussion of this issue. Sometimes the discussions
appear to be going along the route that had been taken by the Christian
scholars and reformists during the process of legalizing riba.

Views of the Mazhab on Riba

There are slight differences of opinion among the four mazaahib on

the prohibition and the form of riba involving debts or loans. With
 THE CONCEPTS Of INTEREST, I'SVRE AND KIH1 205

regard to debt riba, they are all in agreement that every loan that
produces an advantage is riba. However, Ibn Hazm (384 H/994-
456 H/1064) in his book, Al-Muhalia was of the view that riba is not
allowed in a sale or delayed payment except in six items, namely
gold, silver, wheat, barley, dates and salt; but for loans, riba covers
everything (Homoud, 1985). Riba, however, is not committed in the
case of an additional amount paid by the debtor over the principal
if there is no expressed agreement which requires the debtor to do
so. This is in line with the Hadith narrated by Abu liurairah who
reported that the Prophet (p.b.u.h,) had said, "The best of you is he
who repays best.” (Homoud, 1985, p. 87). There are some differences
of opinion among the mazhab related to the Hadith, "Gold for gold,
silver for silver..." Based on this Hadith, the meaning of riba in the
Syariah context is the unlawful gain derived from the exchange of
two or more items in the same /ins (group) that are governed by the
same ilia (process of formation).
The various views of the mazaahib on Riba al-Fadl and Riba
al-Nasiah may be summarized below (Saleh, 1986, pp. 20-26).
The description only covers the four principal mazaahib.
The opinions of other mazaahib will not be discussed. (Al-Zuhavli
(2003) has also written in detail on this matter.)

Hanafis
(i) The exchanged countervalues are all measurable or all
weighable and belong to the same genus. For example, the sale
of wheat for wheat.

No gain permitted in a hand-to-hand transaction and no deferred

transaction, even without gain.

(ii) The exchanged countervalues are all measurable or all

weighable but belong to different genera. For example, the
sale of gold for silver.
206 CHATTER 4

No deferred transaction permitted, even without gain. Increase

permissible in a hand-to-hand transaction.

(iii) The exchanged countervalues are not measurable or weighable

but belong to the same genus, such as the sale of an animal for
an animal.

No deferred transaction permitted even without gain. Cain

permissible in a hand-to hand transaction.

(iv) One of the exchanged countervalues is measurable while the

other is not (whether weighable or not). For example, sale of
wheat for silver or pomegranate.

Cain permissible whether in a hand-to-hand transaction or in a

deferred one.

(v) One of the exchanged countervalues is weighable while the

other is not (whether measurable or not). For example, the sale
of gold for wheat or quinces.

Gain permissible whether in a hand-to-hand transaction or in a

deferred one.

(vi) The exchanged countervalues are not measurable or weighable,

and furthermore belong to different genera. For example, the
sale of pomegranates for apples.

Cain permissible whether in a hand-to-hand transaction or in a

deferred one.

Shafiis

(i) The exchanged countervalues are all currencies or all foodstuffs

and belong to the same genus. For example, the sale of gold
for gold or dates for dates.
 nit concepts or interest; usury and riba 207

No gain permitted in a hand-to-hand transaction and no deferred

transaction permitted, even without gain.

(ii) Theexchanged countervalues are all currencies or all foodstuffs

but belong to different gene'ra. For example, the sale of gold
for silver or dates for wheat.

No deferred transaction permitted even without gain, Gain

permissible tn a hand-to-hand transaction.

(iii) One of the exchanged countervalues is foodstuffs, the other is

not. For example, the sale of wheat for iron.

No deferred transaction permitted even without gain. Gain

permissible in a hand-to-hand transaction.

(iv) The exchanged countervalues are neither foodstuffs nor

currencies, whether or not they belong to the same genus. For
example, the sale of chalk lime for lime or lime for lead.

Gain permissible whether in a hand-to-hand transaction or in a

deferred one.

(v) One of the exchanged countervalues is currency, the other is

not, whether or not foodstuffs. For example, the sale of rice for
silver and iron for gold.

Gain permissible whether in a hand-to-hand transaction or in a

deferred one.

Hanbalis
(i) The exchanged countervalues are all measurable or all
weighable and furthermore are foodstuffs. For example, the
sale of rice for rice or grain for grain.

No gain permitted in a hand-to-hand transaction and no deferred

transaction permitted, even without gain.
208 CHATTER 4

(ii) The exchanged countervalues are of the same genus (jins)

and all foodstuffs, but neither measurable nor weighable.
For example, the exchange of watermelons for apples, or all
measurable or all weighable but not foodstuffs, such as the
exchange of gold for silver,

Cain permissible in a hand-to-hand transaction but no deferred

transaction permitted, even with no gain.

(iii) The exchanged countervalues belong to different genera

and are properties governed by one ilia, that is, they are all
measurable or weighable or all foodstuffs. For example, the
sale of wheat for barley.

Cain permissible in a hand-to-hand transaction but no deferred

transaction permitted, even with no gain.

(iv) One of the exchanged countervalues is currency and the other

one an article susceptible to riba, that is, measurable, weighable
or foodstuffs.

Cain permissible whether in a hand-to-hand transaction or in a

deferred one.

(v) The exchanged countervalues belong to different genera and

are governed by different ilia. For example, one is measurable
(wheat) and the other is weighable (meat).

Guin permissible in a hand-to-hand transaction but conflicting

opinion regarding deferment, with trend towards permission.

(vi) The exchanged countervalues are all neither measurable nor

weighable nor foodstuffs. For example, the sale of riding
animals.

Gain permissible whether in a hand-to-hand transaction or tn a

deferred one.
 rm: conceits of interest, vseu> ami win 209

Malikis
(i) The exchanged countervalues are all currencies or all storable
nourishment for mankind and belong to the same genus.
For example, tire exchange of dinars for dinars or wheat for
wheat.

No gain permissible in a hand-to-hand transaction anil no deferred

transaction even with no gain.

(ii) The exchanged countervalues are all currencies or all storable

nourishment for mankind but belong to different genera. For
example, the exchange of dirhams for dinars or wheat for
broad beans.

No deferred transaction permitted even with no gain. Gain

permissible in a hand-to-hand transaction.

(iii) The exchanged countervalues are all foodstuffs which are not
governed by the Maliki's ilia whether or not they belong to the
same genus. For example, the sale of bananas for lettuce.

No deferred transaction permitted even with no gain. Gain

permissible in a hand-to-hand transaction.

(iv) The exchanged countervalues are neither edible nor drinkable

but are all either weighable or measurable, belong to the same
genus and furthermore serve the same purpose. For example,
the sale of material for material.

No deferred transaction permitted even with no gain. Gain

permissible in a hand-to-hand transaction.

Apart from the opinions expressed by the four mazhab on the

existence of the elements of riba in various situations and types of
transactions, these mazhab also have differing opinions on whether
Muslims are allowed to deal with riba with non-Muslims. According
to Muslim jurists, transactions carried out by Muslims may be done
210 CMMTKK4

in three different regions. The first region is known as dar al-Islam,

and comprises countries where Islamic laws are applied and are
under the rule of Muslims leaders. The second region is called dur
al-Harb. Countries in this category have the potential to be at war
with Muslims. The third region is called dar al-Sulli. and comprises
countries which have an agreement with Islamic countries and are
neither under the rule of a Muslim sovereign nor potentially at war
with the Muslims (Saleh. 1986).
Imam Abu llanifa (80 H/699-150 H/767), the founder of the
Hanafi School of Law. allowed Muslims to enter non-Muslim
territories and trade on the basis of riba. Abu Hanifa also allowed
Muslims to trade on a similar basis with converted Muslims from
non-Muslim countries. The Imamate of Syiah is also of the opinion,
with regard to transaction with non-Muslims, that it is unlawful
for Muslims to accept riba but not to give riba (Homoud. 1985).
The Shafts, Malikis and Hanbalis do not share the opinion of the
Hanafis. They believe that there should be no segregation in the
prohibition of riba. Since riba is prohibited in Muslim territories, the
same rule should be applied in non-Muslim territories. Similarly, if
it is unlawful for Muslims to accept or give riba to fellow Muslims,
the same should be applied to transactions with non-Muslims
(Homoud, 1985).

Views of Modern Scholars

One of the controversial views pertaining to riba was given by
Syeikh Muhammad Abduh (1849-1905), the Mufti of Egypt. Abduh
was known as a person with sharp intellect and an open mind.
Many alleged that Abduh had issued a fatwa that the interest paid
by the Post Office Savings Fund was not riba. However, Muhammad
Rasyid Redha (a student of Abduh) denied that the Mufti had
issued such a fatwa. but confirmed that certain government officials
including the Director of Posts had a private discussion with the
 inc CONCEITS or INTEREST, USURY AND HUM 211

Mufti on tliis matter. The magazine. al-Manar, in its December

1903 issue, published a statement from Abduh which read: "The
stipulated usury is not permissible in any case, whereas the Post Office
invests the monies taken from the pepple, which are not taken as loans
based on need, it would be possible Io apply the investment ofsuch monies
on the rules of partnership in commendam." (Homoud, 1985, p. 122).
This statement created much controversy regarding its validity
and authenticity.
Another somewhat different view on riba was expressed by
Jawish (1908). He believed that riba as referred to in the Quran is
the multiple delayed payment riba, and not interest on loans. With
regard to riba on loans, Jawish believed that it was taken not from
the Quran but from procedural rules. Redha (1929) also expressed
his opinion on matters relating to riba. One of the most controversial
statements he issued is that it is permissible for a person to borrow
$100 and sign a note for $120, and this practice is not absolute riba.
According to Redha, delayed payment riba takes place upon the
extension of debt upon maturity.
Statements made by Jawish and Redha did not openly encourage
Muslims to be involved in riba. Maruf Dawalibi, a modem Muslim
scholar believed that a reasonable interest rate should be allowed for
loans of production. This view was supported by another scholar,
Syeikh Abdul Jalil Isa. During the Scientific Conference of Islamic
Jurisprudence held in Paris in the year 1951, Dawalibi said:

The banned usury takes place in loans meant for consumption and not
for production, wherein the former sector the usurers take advantage
of the need of the poor and destitute to exhaust them with exorbitant
usury they impose oil them. Nowadays, as the economic systems have
been developed and many companies have been established, where most
of the loans are being granted for production not for consumption, it
is necessary to consider what development must be introduced to the
stipulations in consequence of this development of civilization.
(Homoud, 1985, p. 120)
212 CHATTER 4

Abdullah Yusuf Ali (1872-1948), one of the leading contemporary

Muslim scholars, was reported as saying:

Our ulama (Muslim learned scholars) both ancient and modern,

have worked out a great body of literature on riba, based mainly on
economic conditions as they existed at the rise of Islam. I agree with
them on the main principles, but respectfully differ from them on the
definition of riba. The definition I would accept would be: undue profit
made, not in the way oflegitimate trade, out ofloans ofgold and silver,
and necessary articles offood, such as wheal, barley, dates and salt
(according to the list mentioned by the Holy Apostle himself). My
definit ion would include profiteering ofall kinds, but exclude economic
credit, the creature of modern banking and finance.
(Zakaria, 1989, p. 41)

During the 1965conference organized by Islamic Research College,

University of al-Azhar, Egypt, the decision on the legality of riba
was made whereby a resolution was passed which reaffirmed that
interest on all types of loans, regardless of the size is considered
riba and haram (illegitimate). The decision made was regarded as
the conclusion to the discussion on the status of the legality of
riba as offered by modern conventional banks. On Riba al-Fadl. a
controversial view was offered by Mahmud Abu al-Saud (1992).
He believed that this type of riba is lawful and defined it as anv
arrangement whereby an immediate exchange of goods of the
same kind takes place when one person receives from the other
something more in quantity than what he has given. Since the
transaction involved is merely an exchange or barter, it cannot
be regarded as such except when there is a difference between
the things exchanged. Al-Saud subsequently gave the example
of a person who wished to exchange low quality dates with
dates of a superior quality. It was reasonable to expect that the
number of the inferior dates exchanged would be more than that
of the superior quality dates. Therefore, in this case the exchange
process was lawful and permissible. This view, according to
 Im CONCEPTS of iNii Risr, USUK» AND nu 213

him, is in line with the opinion given by one of the early Muslim
scholars, Ibn Hazm (384 H/994-456 H/1064), but contrary to the
opinion of Ibn Qayyim (1292-1350) (al-Saud, 1992). In contrast
to the view expressed by al-Sayd, Syeikh Tantawi, the Grand
Mufti of Egypt and the Chairman of the al-Azhar Research
Academy, stated that interest-paying government bonds were
in conformity with Islam. This caused an outrage from many
Muslim scholars (Mallat, 1996). Apart from this, on 12 July 1989,
Syeikh Tantawi also issued a fatwa in the Al-Ahram newspaper
that the interest from certificates of investment issued by Bank
Al-Ahli in Egypt was not haram. A further two fatwa were released
by Syeikh Tantawi, in November 1989 and 1991, where he declared
that bank interest was permissible in Islam (Al-Zuhayli, 2003).
However, Syeikh Tantawi had earlier issued a contradicting fatwa,
where he declared that interest given by banks was haram.
Countries in South East Asia, with the exception of Indonesia,
have not discussed the permissibility or prohibition {halal or haram)
of riba in detail or depth, in Malaysia, for instance, a complete
collection of fatwa on riba, whether those issued by individuals or
organizations, has yet to be published. To date, no scholars and
ulama have openly declared that bank interest is not haram. This
does not, however, mean that scholars in Islamic studies, ulama
(mufti), and Religious Councils have never issued any fatwa on riba.
For example, the late Syeikh Alwi bin Tahir al-Haddad, the former
Mufti of Johore, frequently issued fatwa on this matter which were
used as a source of reference by the Mufti of Brunei. A collection of
fatwa by Syeikh Alwi was published in Kumpulau Fatwa-Fatwa Mufti
Kera/aan fohor Penggal 1 dan 2. The staff of the Mufti Department of
the Government of Brunei Darussalam were among those who had
published collections of fatwa on matters associated with muamalat
with a special chapter on the issues of riba (Jabatan Mufti Kerajaan
Brunei, 2000). Fatwa on riba have been issued by the Mufti of Brunei
since 1964. Based on the compilations issued from 1962 to 1999, there
was no fatwa found to be against the views of the mainstream.
214 CHAFTKR 4

The discussions on riba by Muslim scholars in Indonesia were

conducted on a larger scale compared to Malaysia. Apart from the
fatwa issued by the scholars, Islamic groups or associations also
issued their own fatwa on riba. Discussions on riba in Indonesia were
conducted in 1927 by the group, Nadhatul Ulama in Surabaya, and
subsequently in Magelang in 1939 and Cilacap in 1981. However,
their views on the legality of riba were inconsistent. Some contended
that riba was haram, others argued that it was halal, while there were
also those who declared it to be something of doubt or syubhah.
Detailed study conducted bv Antonio (2004) on the views of the
Indonesian society on riba had shown inconsistencies in the views
among the scholars and ulama. These contradictory views continue
to this day. In his study, Antonio investigated the opinions of
45 renowned Indonesian scholars and ulama. including ulama from
Muhammadiah, Nadhatul Ulama, Persatuan Islam and Majlis
Ulama Indonesia. There was a surprising finding from his study:
24 participants believed that interest paid or imposed by banks was
not haram. Many were of the view that riba was only haram if it
harmed or hurt the recipient, and that only exorbitant interest was
regarded as riba. Among the renowned ulama and scholars who
regarded riba as halal were Ibrahim Hosen. Abdurrahman Wahid
(a former President of Indonesia) and Hasan Basri.

SUMMARY

Islam forbids its followers to accept and give riba. This prohibition
is clearly stated in the Quran and Hadith. Nevertheless, the
involvement of humans in interest loans had existed since the
Sumerian period. The practice of applying interest on the lending
system was then continued by other civilizations such as Babylonian.
Assyrian, Neo-Babylonian, Persian, Greek and Roman civilizations.
Nonetheless, religions at that time held differing views on this
 THE CONCEPTS OT INTI BEST, USURY AND IWI.l 215

practice of accepting and giving interest. In addition, various views

and conceptions were also presented by religious scholars and
philosophers of earlier civilizations which al times differed from
those of scholars in other civilizations. For example, the original
concept of interest was that of compensation on the loss on the part
of the creditor resulting from the debtor's failure to repay his debt
upon maturity. Today, interest is defined as the additional amount
required to be paid by the borrower on repayment of his loan. As for
usury, it originally meant "interest". However, when the Christians
legalized interest in 1836, usury was regarded as illegal interest ora
rate exceeding the legal rate set by the authorities. From the Islamic
perspective, riba refers to the amount of extra payment made on the
principal loan, regardless of the size of the amount borrowed.
Although the Jews were not prohibited from taking interest
from foreigners outside the Jews community, they were forbidden
from taking interest from their own kind. The Christians, on the
other hand, were originally prohibited from charging interest
on loans. From the early Christian period until the 12th century,
various condemnations were thrown by Fathers of the Church
towards those who dealt with interest. In fact, some went to the
extent of declaring that those involved in interest were to be
ostrasized from the religion. However, the rapid development of
trade and commerce in the 12th century changed the conceptions
about interest to the extent that some Christian scholars began to
view it as legal. Eventually, the discussion on the concept of interest
took on various angles including legislative, economic, social and
religious perspectives. In time, interest was made permissible in
Christianity.
In contrast with other religions, Islam otters a definite guidance
which forbids Muslims from dealing with riba. The prohibition
of riba is revealed in four chapters in the Quran. Hadilh related
to riba can be classified directive Hadith, explanatory Hadith and
reminder Hadith. Guidance given by both sources had prevented
any serious conflicting views on riba among Muslim scholars. All
216 CHAITr.R4

scholars concurred that riba is illegitimate or luiram regardless of

the size of the loan. Furthermore, all types of riba are considered
illegal regardless of whether they originate from productive loans
or consumption loans. Presently, a group of scholars and ulama,
particularly in Indonesia, proclaimed that interest as practised bv
conventional banks is not haram. The most distinct group voicing
this stand are the ulama and religious figures in Indonesia. They
based their arguments on the grounds that interest is only regarded
as haram if the amount is exorbitant and it oppresses the debtor.
In addition to this point, other reasons for legalizing riba were
inflation and that lending money creates economic benefits. This is
actually perturbing, for these reasons put forward by the Muslim
scholars were the very ones given by Christian scholars 500 years
ago when they legalized riba. If these arguments continue to gain
ground, it will hardly come as a surprise if one day all ulama were
to contend that riba is halal. If this happens, there will no longer be
any difference between Islamic and conventional banks.

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shim
 CHAPTER

LAWS AND REGULATIONS OF

ISLAMIC BANKING

This chapter discusses the Ims and regulations to be complied with

and adhered to by an Islamic bank. 4s institutions based on Islamic
doctrines, Islamic banks must operate within the ambit of Islamic
principles and laws. In addition, the banks must conform to man-made
laws or positive laws.

INTRODUCTION

Islamic banks all over the world are required to comply with two
kinds of laws, namely Islamic laws and positive laws. Just as every
Muslim individual is required to do what is commanded of him and
to avoid what is forbidden in Islam, such is also the case with Islamic
banks. The failure to do as recommended by Islamic teachings
would mean that the Islamic banks have not yet fully internalized
and implemented what is required of them. Hence, using Islamic

221
222 CHAPTER 5

terminologies or labelling themselves as Islamic banks would be

questionable. The Islamic laws which need to be complied with by
Islamic banks are known as Syariah law, Positive laws, on the other
hand, are rules and regulations imposed by the government of the
country where the banks operate.
Although Islamic banks are subject to Syariah law, this does
not mean that there exist specific Syariah laws for the control or
administration of Islamic banking operations. Today, there does
not yet exist an Islamic organization in the world which issues
Syariah laws containing provisions to cover the total running and
operations of an Islamic bank. Nevertheless, all regulations and
general guidelines related to the running of Islamic banks are found
in the sources of Syariah law. Syariah law comes from four sources,
namely the Quran, Hadith, ijma and yiyas.
Mannan (1986) in his book, Islamic Economics: Theory and Practice,
stated that the uniqueness of Islam lies in its comprehensive
principles which can be certified at all times, for all mankind.
Islamic laws as a whole are founded on eternal miracle (mukjizat).
The meaning of "miracle" here is that the laws are comparable not
only with fluctuating laws but also with simple and concise laws.
In addition, Islamic laws constantly discover new truths and
guidance for every period and level. Guidance is provided to
mankind by Allah (s.w.t.) to the Prophet (p.b.u.h.) through divine
inspiration (toahyu) which is fundamental and eternal. Islamic law
is an all-embracing body of religious duties, the totality of Allah's
(s.rv.t.) commands that regulate the life of every Muslim in all
its aspects, including religious practices, politics and legislation
(Schacht, 1964). Schacht, an authority on Islamic civilization,
opined that Islamic law was created not by an irrational process of
continuous revelation but by a rational method of interpretation,
which took into consideration both religious standard and moral
values.
 LAW. ANO REGULATIONS OF ISLAMIC BANKING 223

Maududi (1983) in his book, Islamic Law and ConstHution,

presented the view that the principal objectives of Syarialt are to
construct human life on the basis of marufilt or virtues and to cleanse
it of the munkarat or vices. The cony-ept of marufat symbolizes all the
virtues and good qualities that have been accepted as good by the
human conscience. On the other hand, munkarat denotes all the sins
that have been condemned by human nature as evil. The Syariah
gives a clear view of these marufat and stresses that they are the
norms to which individuals and social behaviour must conform.
Positive laws or the laws that are given by a person of authority
are distinct from moral and sacred laws given by God or with God's
guidance. Positive laws at times refer to Western laws and also
secular statutes borrowed by Islamic countries (Saleh, 1986). The
use of these Western laws is the result of historical factors; most
Islamic countries had at one time or another been colonized by
Western powers. I fence, among the legacies of the colonizers are
the laws which have been formulated on the basis of laws used
in the colonizers' countries. Malaysia, for instance, applies laws
which are mostly guided by English laws. Hence, Islamic banks are
required to comply with not only Syariah law but also these positive
laws. In general, most laws that are formulated and imposed on
Islamic banks are under the control and supervision of the central
bank of the particular country. For example, the establishment of
Islamic banks in Malaysia is governed by the Com/’anics Act 1965
and its operations are subject to the Islamic Banking Act 1983.1 lence,
Islamic banks must conform to all requirements as stipulated in
both the acts Similarly, other governments have passed special
laws that govern the operations of Islamic banks in their countries.
For example. Islamic banks in Pakistan and Iran are required to
comply with not only ordinary laws but also specific laws issued to
monitor and regulate Islamic banks.
224 CHAPTER 5

THE CONCEPT AND MEANING OF SYARIAH

The word Syariah originates from syar, which means "the path or
the road leading to the water", and the verb syara'a literally means
"to chalk out or mark out a clear road to the water". In the religious
sense, it means the path to a perfect life or "the highway of good
life". In other words. Syariah is the way which directs man's life to
the right path (Rahman, 1979). From the words "to the right path",
came the meaning of "law" (Denny, 1985). The word Syariah also
has its correlation with the word din which means submission or
following. Syariah is the stipulation of methods or ways and the
principal subject is Allah (s.w.t.), while din is in compliance with
the methods stipulated and the principal subject is man. Hence, one
can use the words Syariah and din interchangeably because both use
the stipulations or commands given by way of the Quran (Rahman,
1979).
The concept of Syariah encompasses not only the conduct of
man in his life towards realizing the Divine Will, but also covers
all behaviour - spiritual, mental and physical. This means that
the concept of Syariah is greater than law, covering all aspects of
living including faith and practices, personal behaviour, legal and
social matters. In other words. Syariah is an all-encompassing,
comprehensive principle of a total way of life. Denny (1985) stated
that Syariah contains all aspects which may positively be termed
laws and is the centre of the Islamic legislation system. Syariah is
something that is perfect and real. Syariah also unites and guides
Muslims at all times and in all situations. It is brought down from
generation to generation and disseminated to all Islamic areas.
Further, according to Denny, Syariah lifts the spirit and renders a
feeling of stability and calm among Muslims.
Ismail (1992) in his elaboration on the origins of Islamic
finance and banking, perceived Islam as comprising three basic
elements, namely Aqidah, Syariah and Akhlaq. Aqidah covers all
 I AWS AND KECHAIIONS <IE ISI AVIl BANKING 225

aspects of belief and faith of Muslims towards Allah (s.w.t.) and

His commands. Syariah covers all forms of actions or practices of
Muslims to demonstrate their belief and faith. Akldaq encompasses
aspects of action, behaviour and ,work ethics of Muslims when
performing an action. The Syariah aspect may be further divided
into two parts, namely Ibadat and Muamalat. Ibadat is concerned
with the practicalities of a Muslim's worship of Allah (s.w.t.), while
Muamalat is about man-to-man relationship. Hence, aspects such
as political, economic and social activities, are all under the ambit
of Muamalat. Since finance and banking activities are part of the
economic activities, these activities are therefore linked to Syariah
principles through Muamalat. The relationship between Syariah and
the Islamic banking system is shown in Figure 5-1.

FIGURE 5-1 Relationship Between Islamic Banking System

and Syariah

ISLZIM

1
AQIDAH | | SYARIAH | | AKHLAQ
1
IBADAT MUAMALAT

POLITICAL ECONOMIC SOCIAL

ACTIVITIES ACTIVITIES ACTIVITIES

BANKING & FINANCIAL

ACTIVITIES

Source: Ismail. 1992, p. 250.

226 CHArtiKS

Doi (1984) was of the view that Syariah is different from all other
laws because the Quran and Sunnah are gifts from Allah (s.w.t.)
whose value to the ummah is beyond any form of comparison.
Since the various communities in the ummah are collectively
responsible for administering justice, Muslims or others living in
peace and harmony in Islamic countries have the right not to be
violated by any ruler or legislative council. Ali (1950) saw Islam as
two parts, theoretical and practical. The theoretical aspects include
matters related to faith and its doctrines, and these aspects are
called usul or the origins of a principle. These theoretical aspects
are also commonly termed as aqa'id (singular: atjidah) which means
beliefs. Practical aspects include all that a Muslim is required to
do. These practical aspects are known as fiirw (singular: far) which
means branch; it is also called ahkam (singular: hukm) which means
ordinances or regulations of Islam. Consequently, the existence of
Islamic banking system is governed by the practical aspects of Islam
and must therefore conform to the ahkam of Islam. These aspects
may be listed or are found in all Islamic ahkam.
There are five types or categories of ahkam in Syariah law as
listed below.

(i) Card or wa/ib

Compulsory duties and acts to be' performed by all Muslims.

Performance is rewarded and omission is punished.

(ii) Sunna, masnun, mandub or muslahabb

Duties and acts that are recommended but not required.

Performance is rewarded, but omission is not punished.

(iii) /a'iz or mubah

Indifferent actions whose performance or omission is neither

rewarded nor punishable.
 LAWS AND REGULATIONS OF ISLAMIC BANKING 227

(iv) Makruh

Actions that are disapproved but not punished or forbidden.

(v) Haram

Actions that are both forbidden and punishable.

SOURCES OF SYARIAH

There are four fundamental sources of Syariah law. The first source
is the Quran, the holy book of the Muslims. The Quran is the
authentic and eternal source of Syariah law. It constitutes messages
that Allah (s.w.t.) presented to the Prophet (p.b.u.h.) for the
guidance of mankind. These messages are universal, eternal and
fundamental.
The second source of Syariah law is the Hadith, which is next in
importance to the Quran. Hadith refers to information, accounts,
narratives, stories and records of the Sunnah of the Prophet
(p.b.u.h.) which have been handed down from generation to
generation to become the rule of faith and practice of Muslims.
Sunnah (plural: sunan) describes the customs, habits and usages
of the Prophet (p.b.u.h.). It also describes the Prophet's (p.b.u.h.)
behaviour, actions, his sayings and declarations under a variety of
circumstances in life.
The third source is called ijma. lima means a consensus of opinion
of the mujtahid or an agreement of Muslim jurists of a particular age
on a question of law. Mu/tahid are learned scholars of Islam or those
authorized to exercise independent legal reasoning. The process
whereby these experts discuss in full seriousness the solution to a
particular religious issue is called ijtihad.
The fourth and final source is qiyas which literally means
"measuring by" or "comparing with" (Ali, 1950). In Syariah terms.
228 CHArttR 5

qiyas is the process of reasoning by analogy of the mujtahid with

regard to difficult and doubtful questions of doctrine or practice, by
comparing them with similar cases already settled by the authority
of the Quran and Hadith and thus arriving at solutions of undecided
questions.
Both the Quran and Hadith are also known asal-adillat-al-qatiyyah
meaning absolutely certain arguments of infallible proof. This is
because these two sources contain absolute truth and undoubted
fundamental doctrines of Islam. These sources are also sometimes
referred to as usul or the principal root of Syariah. lima and qiyas are
known asal-adillal-al-iitihadiyyah or arguments obtained by exertion.
These two sources are also called furu or .1 branch of Syariah law.
Within these four frameworks, the Syariah law is able to deal with
the complexity of today's dynamic world and is capable of handling
various conflicting problems of modem life.

The First Source: The Quran

The Quran is the foundation of Islam and is the principal Book
on the religion and moral principles. The Quran was revealed by
Allah (s.w.t.) to the Prophet (p.b.u.h.) through a process called wahy
malli/ww or revelation that is recited. In this case. Gabriel or the Holy
Spirit who acted as an intermediary gave directly to the Prophet
(p.b.u.h.) divine messages from Allah (s.w.t.). This holy Book
consists of 111 chapters of different lengths, called surah, each one
with its own title. The actual meaning of surah is eminence or high
degree. The surah contain verses which are meant as guidance or
communication from Allah (s.w.t.). Without counting “Bismillah..."
as a verse, there are 6,2411 verses in the Quran. I lowever, there exist
minor disagreements in opinion in terms of the total number of
verses as a result of the different methods used to compute them by
centres of Quranic learning (Ali. 1950). According to Doi (1984), the
total number of verses in the Quran is 6,666.
 LAWS AND REGULATIONS <>L ISl AMIC BANKING 22')

In general, the longer surah are placed in the earlier part of the
Quran. Some of the verses in the surah are arranged according to
the occurrence of events, while some are grouped according to the
matter being discussed. Basically, chapters in the Quran are divided
according to the place of revelation. The surah revealed in Mecca are
called .Mecca Surah and those revealed in Medina are called Medina
Surah. According to Ali (1950), 92 surah were revealed in Mecca and
the rest in Medina.
There are three broad features which distinguish the two
revelations. First, Mecca revelation deals chiefly with faith in God
and is particularly devoted to grounding Muslims in the faith,
while Medina revelation is chiefly intended to translate that faith
into action. Secondly, Mecca chapters are generally prophetical,
while those from Medina deal with the fulfilment of prophecy.
Thirdly, while the Mecca revelation describes how true happiness
of mind may be sought in communication with God, the Medina
verses point out how man's dealing with man may also be a source
of bliss and comfort to him.
The word Quran itself is frequently mentioned in the Quran
(Q2: 185; Q10: 37 and 61; Q17: 106). Imam Allama Abu-I-Fadzl
Jamal al-Din Muhammad ibn Mukarram in his writing, Lisan
al-Arab, said that the root of the word Quran is the word Qara'a
which means "to put together items". Imam Abu-I-Qasim al-Husain
ibn Abu-l-Fadzl al-Raghib in his book, Al-Mufridatfi Gharibi-I-Quran
stated that the word Quran means "to read" or "to verbalize". This
is because in reading or verbalizing, letters and words are joined
according to certain rules (Ali, 1950). Due to the fact that this
Book contains wahyu from Allah (s.w.t.) which was revealed to the
Prophet (p.b.u.h.) from time to time, it is also known as Ka/am-Allah
or words from Allah (s.w.t.).
The Quran is also known by various other names, and these
names are mentioned in a number of verses in the Quran itself.
Among them are al-kitab (Q2: 2) which means complete writings;
al-Khair (Q3: 103) which means good; al-Bayan (Q3: 137) which
230 CHATTCR 5

means explanation; al-Burhan (Q4: 175) which means view;

al-Muhaimin (Q5: 48) which means guardian; al-Nur (Q7: 157)
which means light; al-Mau'izah (Q10: 57) which means advisor;
al-Shifa (Q10: 57) which means healer; al-Hukm (Q13: 37) which
means judge or implementor of rules; al-Dikra and al-Tadhkirah
(Q15: 9) which mean provider of reminders or source of nobility
and victory for man; al-llikmah (Q17: 39) which means wisdom;
al-Haqq (Q17: 81) which means truth; al-Rahmah (Q17: 82) which
means forgiver; al-Qayyim (QI 8: 2) which means care-giver;
al-Furqan (Q25: 1) which means the one that differentiates between
truth and falsity and between pure and fake; al-Tanzil (Q26: 192)
which means statements from up high; Ahsan-al-Hadith (Q39: 23)
which means the best sayings; al-Ruli (Q42: 52) which means the
soul of life; and al-Naimah (Q93:11) which means blessings.
Apart from the abovementioned names, there are many more
names which can be used to describe the Quran. Among the
important issues that Islamic scholars frequently argue about is the
interpretation and commentary of the real meaning of the verses of
the Quran. The rule for the interpretation of the Quran is given in
verse 7, Surah Ali Imran.

It is He who has sent down to thee the Book: in it are verses basic or
fundamental <of established meaning); they are the foundation of the
Book; others are allegorical. But those in whose hearts are perversity
follow the part thereof that is allegorical, seeking discord, and searching
for its hidden meanings, but no one knows its hidden meanings except
Allah, And those who are firmly grounded in knowledge say: “We
believe in the Book: the whole of it is from our Lord": and none will
grasp the Message except men of understanding. (Q3:7)

Fundamental (mnhkamaaf) verses are those whose meanings are

clear and can be easily understood. Allegorical (mutasyaabihaal}
verses carry various meanings and the intended meaning cannot
be determined unless by in-depth study, and even then the full
actual meaning is only known to Allah (s.w.t.). The verse above
 LAWS AND REGULATIONS OF ISLAMIC BANKING 231

also provides a clear guideline to those intending to interpret the

Quran. Abdullah Yusuf Ali (1872-1948), a renowned interpreter
of modern times, believed that the verses can be divided into two
parts which are closely interconnected. The first part is the essence
or foundation of the holv Book or better known as "the mother
of the Book", and the second is the part where the meaning is
not so clear. Abdullah Yusuf Ali further said that it is fascinating
to seek the meaning of something unclear, using ingenuity to
discover the hidden meaning. Nevertheless, such effort requires
spiritual elements and its depth is beyond the human language.
Those of wisdom may obtain a certain amount of light from it, but
nobody should be dogmatic, claiming his interpretation alone to be
correct and irrefutable, as only Allah (s.w.t) alone knows the true
meaning of the verses. According to Ali (1950), the most important
principle and one which must be borne in mind in interpreting the
Quran is that the meaning must be sought within the Quran itself.
The interpretation made must not be in conflict with other verses,
in particular with the verses whose meanings are clear.
Doi (1984) classified those who produce wrong interpretations
into four groups, namely/asidmi, that is those who cause destruction
or disasters;/osiipm, those who rebel; zalimun, those who do wrong;
and kafirun, the non-believers. According to Doi, the following
characteristics are required of those who wish to interpret the
Quran:

• Possess in-depth and detailed knowledge of tire Arabic

language.

• Possess wide knowledge of llm al-Ma'ani or rhetorics (the art of

using words effectively).

• Possess great, profound and complete knowledge of / ladith.

• Able to use knowledge of Hadith to identify verses which are

unclear in meaning (mubham) and to provide an explanation for
them in a concise (mu/rnal) manner.
232 CHArTFK 5

• Highly knowledgeable in asbab ai-Nuzul, that is, knowledge

about the reasons why particular verses were sent down by
Allah (s.w.t.).

• Highly knowledgeable in nasikh and mansukh, that is, knowledge

about the abolition of a verse and its replacement by another.

• Highly knowledgeable in usul al-Fiqh, that is, knowledge about

the origins of Islamic legislation.

• Knowledgeable in ilni al-Tajwid, that is, knowledge about the

reading of the Quran.

• God-fearing (faipea).

The Second Source: Hadith

The word Hadith means a story, a narration or a report. The original
meaning of the word is "being new" and "occurring, taking place,
coming to pass", and extends to talking about or reporting what
has happened. Hence, Hadith is a narration or report of something
which has occurred. These reports or sayings are conveyed to
another party through hearing or through revelation. The Quran
mentions the word Hadith in SuraJt 18, verse 6 and Snrali 39,
verse 23. Hadith is also known as tradition since it was passed
down from person to person and from generation to generation.
In the context of Syariah. Hadith refers to the Sunnah of the Prophet
(p.b.u.h.). As a source of Syariah law, Hadith is used to confirm,
verify, extend, elaborate, explain and complement the verses of the
Quran.
Sunnah literally means a way or rule or manner of acting or
mode of life (Ali, 1950). The Quran also mentions Sunnah in general
to mean "ways" or "rules" The term sunnat al-awuvlin is used in
several Quranic verses (Q8: 38; Q15: 13; Q18: 55; and Q35: 43) where
the term means "the ways or examples from people in the past".
 l-AWS ANO RF.GVLATIONS OF ISLAMIC BANKING 233

and it describes the way Allah (s.w.t.) deals with mankind. Rahman
(1979) described the word Sunnah as "a trodden path" and each
part of the path is considered a Sunnah, regardless of its position,
whether near to the starting pointer remote from it. There are three
types of Sunnah. The first is qaul or the words spoken by the Prophet
(p.b.u.h.) which are related to religious issues. The second is fi'il,
which describes the actions or practices of the Prophet (p.b.u.h.).
The third is taqrir, which means the Prophet's (p.b.u.h.) silent
approval of the actions or practice of another. If He does not forbid
someone from performing a certain action, it is taken as the Prophet
(p.b.u.h.) agreeing to the action.
The use of Hadith as the second most important source in Syariah
is in agreement with a number of verses in the Quran. In those
verses, Allah (s.w.t.) commands the believers to obey Allah (s.w.t.)
and His Apostle. The following are examples of such verses.

Allah (s.w.t.) says in Surah Ali Imran, verses 31-32:

Say: “Ifye do love Allah,follow me: Allah s.w. t. will loveyou andforgive
you your sins: for Allah s.w.t. is Oft-Forgiving, Most Merciful."

Say: "Obey Allah s.w.t. and His Messenger": But if they turn back,
Allah s.w.t. loveth not those who reject Faith. (Q3:31-32)

In Surah an-Nisaa. verse 59, Allah (s.w.t.) says:

O ye who believe! Obey Allah, and obey the Messenger, And those
charged with authority among you. If ye differ in anything among
yourselves. refer it to Allah s.w.t. and His Messenger, if ye do believe
in Allah s.w.t. and the Last Day: that is best, and most suitable for
final determination. (Q4: 59)

Further, Allah (s.w.t.) says in Surah al-Hasyr, verse 7:

... So take what the Messenger assigns to you, and deny yourselves
that which he withholds from you. And fear Allah; for Allah s.w.t. is
strict in Punishment. (Q59: 7)
234 CHAFTFHS

After the death of the Prophet (p.b.u.h.), the need to understand

the sayings and deeds of the Prophet (p.b.u.h.) gave rise to the
widespread usage of the Hadith among the Muslim ummah. The
period in which the Hadith was extensively used may be divided
into four. The first was the period of the Companions (Sahabat); the
second period was the time after the Companions or the period of
the followers of the Companions; the third was the period after
the followers of the Companions. It was in this third period that
studies began towards arranging the Hadith according to particular
groupings. Among the Companions who contributed towards the
development of the Hadith are as follows (Doi. 1984):

• Companions who narrated more than 1,000 Hadith:

Abu Hurairah 'Abdur Rahman (m. 59 H) - 5.374 Hadith

AbdAllah s.w.t. bin 'Abbas (d. 68 H) - 2,660 Hadith
Ummal-Muminin (d. 58 H) - 2,210 Hadith
'Abdallah s.w.t. bin 'Umar (d. 78 H) - 1,560 Hadith
Anas bin Malik (d. 93 H) - 1,286 Hadi th
Abu Said Khudri (d. 74 H) - 1,170 Hadith

• Companions who narrated between 500 and 1.000 Hadith:

'Abdallah s.w.t. bin 'Umru bin al-'As (d. 63 H)

Saydina 'Umar (d. 23 H)
Saydina 'Ali (d. 40 H)

• Companions who narrated between 100 and 500 Hadith:

Saydina Abu Bakr (d. 13 H)

Saydina Uthman (d. 36 H)
Umm Salmah (d. 59 H)
Abu Musa Ash'ari (d. 52 H)
Abu Dhar Ghaffari (d. 32 11)
Abu Ayyub Ansari (d. 51 H)
Ubayy bin Ka'ab (d. 19 H)
Mu'adh bin Jabal (d. 18 H)
 LAWS AND REGULATIONS OF ISLAMIC BANKING 235

The second period of the development of the Hadith was the

period after the Companions, around the middle of the second
century of Hijrah. Among the followers of the Companions, or the
Tabi'in, who contributed a great deal to the development of Hadith
were Said bin Musayyib (d. 105 H), Urwah bin Zubair (d. 94 if),
Salim bin'Abdallah s.w.t. bin'Umar (d. 106 H), Nafi Maula'Abdallah
s.w.t. bin 'Umar (d. 117 H) and other followers of the Companions
such as Muhammad bin Shitab Zuhari (d. 124 H), 'Abdal-Malik
bin Jarih (d. 150 H), Imam Auzai (d. 157 H), Ma'mar bin Rashid
(d. 153 H), Sufyan al-Thawri (d. 161 H), Hammad bin Salmah
(d. 167 H), Abdallah s.w.t. bin Mubarak (d. 181 H) and Imam Malik
bin Anas (d. 179 H).
The second period started at the end of the second century of
Hijrah. During this period, attempts were made to compare the
Hadith of the Prophet (p.b.u.h.) as reported by the Companions
against what was reported by the followers of the Companions.
At that time, there were two types of Hadith, Musnad and Jami'
or Musannaf. Musnad comes from the word sanad which means
authority. The presentation order of Hadith based on ntusnad is
made according to the names of the first Companions who had
narrated the Hadith, rather than based on topics. Hence, a Hadith
has two important elements, that is, isnad, which means the
link or chain of authority right up to the root source of a Hadith,
and matn, which is the meaning of the content of the Hadith.
The most important compilation of Hadith that followed this
method of presentation order is Imam Ahmad ibn Hanbal's
(164 H/778-241 H/855) Musnad.
Presentation based on jarni' (something collected together)
or musannaf (implemented or obeyed together) was carried out
later than the nmsnad method. In this method, compilations and
presentations were done based on the subject covered in a particular
Hadith. Some of the most important Hadith in this group are
those by Imam Muhammad bin Ismail al-Bukhari (d. 256 H/870),
Imam Muslim bin Hajjaj al-Qushayri (d. 261 H/875), Imam Abu Daud
236 CHATTER 5

Ashath al-Sijistani (d. 275 H/889), Imam Abu Ismail al-Tirmidhi

(d. 279 H/893), Imam Muhammad bin Yazid Ibn Majah al-Qazwini
(d. 273 H/886) and Imam Ahmad bin Shu'aib al-Nasai (d. 303 H/916).
The third period of the development of the Hadith began in the
early fifth century' of Hijrah and continues until today. However,
most of the works in this period are in the form of commentaries of
earlier works. Among the well-known works are Miskat al-Masabih
by Wall al-Din al-Khatib, Kiyad al-Salihm by Abu Zakariya Yahya
bin Sharf al-Nawawi (d. 676 H), Muntaqial-Akhbar by Abul Barakat
Abdus Salam Ibn al-Taimiyyah (d. 652 H), Bulugli al-Maram by­
Hafiz Ibn Hajar (d. 752 H) and Siibul al-Salam by Muhammad bin
Isma'il (d. 1182 H).
A variety of methods are used by' learned scholars in classifying
Hadith into categories or organizing them into particular groupings.
A Hadith may be classified according to: the number of narrators
who narrated it; the features of the isnnd, that is the features that
link the narrator and the source of the Hadith; whether a particular
Hadith is adopted or rejected; and finally, specific characteristics
found in the isnad and main of a particular Hadith.
The first method of classification that is based on the number of
narrators, may be further broken down into the following types:

• Mutawatir hadith

Hadith of this type were narrated by many narrators with no

conflict among them.

• Mashur hadith

Hadith of this type were narrated by more than two narrators.

Not all Hadith of this type can be regarded as sahih. that is, not all
can be regarded as adoptable or unquestionable in their truth.

• Aziz hadith

This type of Hadith came from only one narrator, but this
individual was someone who was fully trusted and accepted as
 LAWS AND REGULAllONS Of ISLAMIC BANKING 237

a narrator of Hadith. The Hadith recited by this individual was

later taken and narrated by two or three other narrators.

• Ghaib hadith

This Hadith came from one source, whether from among the
Companions or an individual who came later.

• Fard hadith

This Hadith was narrated by only one narrator at each phase or

was only narrated by narrators in the same region.

• Shadhdh hadith

This Hadith came from only one narrator, but this individual
was someone who was fully trusted, and the content of the
Hadith differed from what was narrated by other narrators.

• Ahad hadith

This is a lone Hadith and it was narrated by only one narrator.

Under the second method of classification, the isnad system, musnad

is used to group Hadith where the isnad or link reaches the Prophet
(p.b.u.h.) directly. This type of Hadith is also called niarfu hadith,
regardless of whether or not the link is broken. Mau’kufhadith has at
the beginning of its isnad the Companions of the Prophet (p.b.u.h.),
while maktu hadith begins with those after the Companions. The
Hadith whose isnad is not broken is termed muttasil niarfu if the link
reaches up to the Prophet (p.b.u.h.), and muftasil mawkuf if it ends
with the Companions. Munfasil. which means broken or separated,
is a Hadith with breaks in the link. Imam Shafii and al-Tabrani used
the term munkati for this type of Hadith. If the names of one or two
narrators or all the names of the narrators are not mentioned in
the isnad, then the Hadith is termed mu'Allah s.w.t. hadith, which
means "hanging". Mursal hadith is where the narrator after the
period of the Companions directly extracted the sayings of the
238 CHATTER 5

Prophet (p.b.u.h.) without mentioning the name of tire Companion

concerned. Mu'allal or tna'lul hadith is a Hadith which is weak or
defective in terms of its isnad or matn.
Tlte third method, based on whether the Hadith can be adopted
or rejected, is frequently used. A Hadith can be accepted if it falls
into one of the categories of makbul, maruf or mahfuz. Makbul hadith
is one that fulfils all conditions for adoption, and Is generally
known as sahih and hasan. Marufhadith (can be accepted) is a Hadith
that is somewhat weak but is verified by other Hadith of the same
standing. Mahfuz hadith (fixed in the mind) is of higher standing
than shadhdh hadith.
Hadith which are rejected are those from the group of mardud,
munkar, matruk, malrtih and mawdu. Mardud hadith is a Hadith which
is a contrast to makbul; its narrators were weak or unknown and
its narration differs from what was narrated by those who were
trusted. Munkar hadith (ignored) is a Hadith narrated by only one
narrator and differs from what had been narrated by those who
were trusted. Matruk hadith (disregarded) came from a narrator
known to be a liar or someone who openly behaved immorally and
told lies. Matruh hadith (discarded) is of the same standing as matruk
Mawdu hadith (imaginary') is a Hadith which had been purposely
made up, and of all the rejected Hadith. this is of the lowest type and
as such is regarded as dangerous.
The fourth method which groups Hadith based on specific
characteristics found in the isnad and matn isseldom used. Narrators
of this type of Hadith had the tendency to add their own words; or
to speak on the basis of oath or word of honour, etc. In terms of
Syariah, not all Hadith can be used as a source for formulating laws.
Hadith in the category of sahih (sound) are the primary source of
Syariah law. Sahih hadith are normally broken down into seven main
classes as follows:

(i) Hadith compiled by both Imam Bukhari and Imam Muslim.

(ii) Hadith compiled by Imam Bukhari onlv.

 LAWS ASP REGULATIONS <>l ISI AMIC HANKING 239

(iii) Hadith compiled by Imam Muslim only.

(iv) Hadith not compiled by Imam Bukhari or Imam Muslim but

possess the shurut (conditions) of both.

(v) Hadith which satisfy the shurut of Imam Bukhari.

(vi) Hadith which possess the shurut of Imam Muslim.

(vii) Hadith which are reliable and are compiled by other groups
which can be trusted.

The second group of Hadith which can be used as a source in

formulating law is hasan (fair). This kind of Hadith is not considered
very strong, yet it is necessary for establishing a point of law. Most
of the Hadith concerning legal matters are of this type. The final
category of Hadith is daif (weak) or sakim (infirm). A Hadith of this
type is not acceptable for making rulings although it may be used
to strengthen a hasan hadith if it has similar narration. However, the
usage is considered appropriate only if it deals with exhortations,
stories and good behaviour.
Apart from the Hadith described above, there is one other type of
Hadith which is called kudsi hadith or sometimes known as ilahi hadith
or rahbani hadith. This type of Hadith is different from the nabawi
hadith which is taken from the Sunnah of the Prophet (p.b.u.h.).
This Hadith contains Allah's (s.w.t.) wahyu (divine revelation). Not
all wahyu from Allah (s.w.t.) was sent to the Prophet (p.b.u.h.)
through the angel Cabriel. There were some wahyu acquired by
the Prophet (p.b.u.h.) through inspiration and dreams. The biggest
compilation of kudsi hadith was produced by Muhammad al-Madani
(d. 881 H/1476) in his book al-lthafat ai-saniyya fi l-ahadith al-kudsiyya.

The Third Source: Ijma

Ijma (consensus) was originally the agreement of qualified legal
scholars in a particular generation, and such a consensus of opinion
240 CHATTER 5

is deemed infallible. The emergence of the concept of ijma as a

source of law is in line with one Hadith which states:

"My umat will never agree upon an error. “

Imam Shafii was the first person to introduce this concept as a

source of law after the Quran and Hadith. He refuted that the
agreement reached by Islamic scholars in a certain district cannot
be used for the whole Muslim ummah. Instead. Imam Shafii was
of the view that there exists only one agreement, which is the
agreement reached by the whole Muslim ummah, lima of this kind
must be adhered to and is called ijma of the society. Rahman (1979)
regarded ijma as absolutely authoritative not only for discerning
the right al present and in the future but also in the past, Ijma also
establishes what the sunnah of the Prophet (p.b.u.h.) had been and
indeed what the right interpretation of the Quran is. lima among
the Muslims is not an agreement that can be achieved easily; it
must be arrived at by ijlihad or exertion. Ijtihad is a conscientious
examination and meditation on the subject under consideration.
The desired consensus is normally achieved in three ways. First, it
could be reached by agreement of words or declaration of opinion
in words; secondly, by agreement of act. practice or expressed in
unanimity of action or practice; and thirdly, agreement of silence or
tacit assent by silence or by non-interference. In addition, there is
overall consensus where all parties agree to the decision made.
Mujtahid (learned scholars) who are involved in the process
must be men of honesty and of integrity. Their minds must not be
iniquitous (filsiq) or blinded by passion (liauM). In general, there are
three classes of mujtahid who are given this responsibility. The first is
the absolute mujtahid who has absolute authority and whose sphere
of exertion embraces the whole law. The second is the mujtahid from
a particular mazhab or special school of theology who is an authority
within the sphere of one of the special theological systems. The last
is the mujtahid of special questions and cases which have not been
decided or resolved by any of the mazhab in the past.
 LAWS ANO REGULATIONS OF ISLAMIC BANKING 241

The Fourth Source: Qiyas

The final source of Syariah law is qiyas. The actual meaning of qiyas is
"measuring bv" or 'comparing with". In short, qiyas is an approach
to solve difficult and confusing problems associated with issues
of doctrines or religious practices. The approach uses wisdom of
thought, by seeking realistic reasons and rationale and comparing
the problem at hand with similar problems which have in the past
already been resolved by the Quran and Hadith.
This approach of using reasoning or the exercise of judgement,
in theological as well as in legal matters, plays a vital part in Islam
and the Quran clearly recognizes this process as stressed by Allah
(s.w.t.) in Surah An-Nisaa, verse 83 (Q4: 83) as follows:

When there comes to them some matter touching (public) safety or

fear, they divulge it. If they had only referred it to the Messenger, or
to those charged with authority among them, the proper investigators
would have tested it from them (direct). Were it not for the Grace and
Mercy of Allah unto you, all but a few of you would have followed
Satan. (Q4:83)

Abu-I-Faidz Sayyid Muhammad Murtadza al-Husaini in his book

Taj al-Arus, stated that the authentic word for "seeking knowledge"
is yastanbitun. This word originates from the word istanbat which is
taken from the word nabat al-bi'ra which means "he digs a well to
bring out water". Hence, the word istanbat used among the mujtahid
is taken to mean "to seek and acquire meanings or hidden meanings
through the process of ijtihad" and this applies also to the solution
acquired through qiyas or comparisons (Ali, 1950). Those who do
not use their reasoning faculty are compared to animals and are
regarded as deaf, dumb and blind. Allah (s.w.t.) clearly states this
in Surah al-Baqarah, verse 171 (Q2:171):

The parable of those who reject Faith is as if one were Io shout like a
goat-herd, to things that listen to nothing but calls and cries: deaf,
dumb and blind, they are void of wisdom. (Q2: 171)
242 chai'iiu 5

Similarly, it is stated in Surah al-A'raaf verse 179 (Q7:179):

Many are the linns and mm Wr have made for Hell: they have hearts
wherewith they understand not, eyes wherewith they see not, and ears
wherewith they hear not. They are like cattle - nay more misguided:
for they are heedless (of warning). (Q7:179)

Verse 22 of Surah al-Anfaal (8: 22) also explains:

For the worst of beasts in the sight of Allah s.w.t. are the deaf and the
dumb - those who understand not. (Q8: 22)

The deaf and the dumb in the verse above are those people who
refuse to listen, utter orexpress, and understand the truths regarding
Allah (s.w.t.). Further, in Surah al-Furqan, verse 44 (Q25: 44), Allah
(s.w.t.) says:

Or thinkest thou that most of them listen or understand? They are

only like cattle - nay, they are worse astray in Path. (Q25: 44)

While condemning those who do not exercise their reason or

judgement, Allah (s.w.t.) praises those who perform ijtihad and use
their wisdom. This is evident in Surah .All Imran, verses 190 and 191
(Q3: 190 and 191) which sav:

Behold! In the creation of the heavens and the earth, and the alternation
of Night and Day - there are indeed signs for men of understanding
- Men who celebrate the Praises of Allah, standing, sitting, and lying
down on their sides, and contemplate the (wonders of) creation in the
heavens and the earth, (with the thought): "Our Lord! Not for naught
hast Thou created tall) this! Glory to Thee! Give us salvation from the
Penalty of the Fire." (Q3: 190 and 191)

It is also reported that the Prophet (p.b.u.h.) himself sanctioned

and encouraged reasoning and the exerting of the faculties of
 LAWS AND REGULATIONS OF ISLAMIC BANKING 243

one's mind in order to find the proper solutions for difficult and
doubtful cases of law. The Prophet (p.b.u.h.) is reported by
Abu Daud in his sunan to have approved Mu'adh's answer that
he would use his own considerations in the event that a solution
cannot be found in the Quran and Hadith. In another Hadith, it was
reported that the Prophet (p.b.u.h.) had said:

When a judge gives a decision, having tried his best to decide correctly
and is right, there are two rewards for him; and ifhe gave a judgement
after having tried his best (to arrive at a correct decision) but erred,
there is one reward for him. (Siddiqi, Vol. 3, p. 930)

The above Hadith proves that Muslims need not worry or be afraid
to perform ijtihad. This is because Islam acknowledges and accepts
the possibility of Muslims erring in making decisions. Following
this, there will probably exist differences of opinion between one
generation and another. Normally, there are four aspects that need
to be considered in ijiyas. First, the matter at hand; secondly, the
matter to be used for comparison; thirdly, the similarities that exist
between the two matters; and fourthly, the decision made through
the process of comparison. Use of the ijiyas method needs to comply
with certain conditions, which are:

(i) The definition or practice which will be created is general in

nature and its use is not for something specific.

(ii) The reasons for a particular prohibition or command must be

known and understood.

(iii) The decision made must be based on the Quran or Hadith.

(iv) The decision reached must not be in conflict with verses in the
Quran and Hadith.
244 CHATTEB 5

GENERAL LAWS OF SYARIAH IN ISLAMIC

BANKING SYSTEM

The fundamental goal of Syariah is to construct life on the basis

of virtues and to cleanse it of vices. Consequently, Syariah is
expected to provide not only the right path, but also to govern all
activities of Muslims towards the betterment of the whole ummah.
including attaining rewards in the Hereafter. In reality, instead
of being governed by the Syariah, Muslims are constantly bound
by customary and positive laws. This situation which prevails in
modem times commenced during the mediaeval age of Islam when
the Syariah was frequently set aside by orders of the Caliphs and
governors, particularly in matters related to commerce.
The absence of Syariah to govern the activities of Muslims has
given rise to a new dimension in the status of the relationship
between Muslims and Syariah. The status of this relationship has
become mere moral ties rather than legislative bonds. This state
of affairs occurs even in the Islamic banking system. The moral
relationship is usually based on the principles given by the Quran
and Hadith. The Quran is primarily a book of religious and moral
principles and exhortations. Although the Quran is not a legal
document, nevertheless, it embodies important legal enunciations.
Mannan (1986) opined that if in the modem context laws are
regarded as what man formulates, the Quran does not carry that
meaning and neither is it the essence of ethics. Instead, the Quran
contains basic principles and focuses on noble qualities, and on the
journey and state of man for attaining mercy and bounty when they
arc knowledgeable of the principles. Abd al-Wahhab ibn Khallaf,
a scholar from Egypt, according to Zakaria (1989), had produced
classification of legal provisions found in the Quran. The essence of
the verses relates to the key aspect of a particular matter, although
there is no clear elaboration. This relevance to laws covers aspects
such as sources of laws, constitutional provision, international law.
etc. The breakdown is as follows:
 LAWS AND REGULATIONS Or ISLAMIC RANKING 245

• Source of laws : 5(1 verses

• Constitutional provisions : 10 verses

• International law : 25 verses

• Jurisdiction and procedures : 13 verses

• Penal law : 30 verses

• Civil law : 70 verses

• Family and personal law : 70 verses

• Financial and economic directives : 20 verses

In relation to Islamic banking system, the Quran has given clear

and explicit guidelines that such operations must be free from
all elements of riba. As an ordinary business entity, Islamic bank
is expected to conform to the rules and guidelines given by the
Quran on conducting its business. For example, Islamic banks are
required to fulfil their obligations to their shareholders, depositors,
business partners, borrowers and other customers. This instruction
is clarified by Allah (s.w.t.) in Surah al-Baqarah. verse 177 (Q2: 177),
Surah al-Ma 'idah, verse 1 (Q5:1), Surah an-Nahl, verse 91 (QI 6:91) and
Surah al-lsraa', verse 34 (Q17: 34). Islamic banks are also expected
to uphold trust, justice and fairness in their dealings as urged in
the Quran by verses 58 and 135 of Surah an-Nisaa' (Q4: 58 and 135),
verses 8 and 87 of Surah al-Ma'idah (Q5: 8 and 87), verse 152 of
Surah al-An'am (Q6: 152), verse 90 of Surah an-Nahl (Q16: 90),
verse 35 of Surah al-lsra' (Q17: 35), verse 8 of Surali al-Mu'minun
(Q23:8), verses 8 and 9 of Surah al-Rahman (Q55: 8 and 9) and
verses 32 and 33 of Surah al-Ma'arij (Q70: 32 and 33).
The Quran also provides guidance to Islamic banks for dealing
with those who borrow from them. This is found in Surahal-Baijarah,
verse 280 (Q2: 280) and Surah All Imran, verse 75 (Q3: 75). In terms
of business procedures, the Quran prescribes details regarding the
prosecution of contracts and other covenants involved in contracts.
246 CHAPTER 5

This is stated in Surah al-Baqarah, verses 282 and 283 (Q2:282 and 283).
Islamic banks are forbidden from venturing into businesses which
are unproductive or non-beneficial, as stated in Surah al-Baqarah,
verse 188 (Q2: 188). In addition. Islamic banks are prohibited from
having dealings with businesses which promote obscenity or which
involve the manufacturing, selling and transporting of liquor, the
making and selling of idols and services rendered in or to pagan
places of worship, fortune telling and gambling, prostitution,
and businesses involving usury and briber}'. These prohibitions
are proclaimed through verse 188 and verses 275 to 280 of
Surah al-Baqarah (Q2: 188, 275-280), verse 130 of Surah Ah Imran
(Q3: 130), verses 42 and 90 of Surah al-Ma'idah (Q5: 42 and 90) and
verse 19 of Surah al-Nur (Q24:19).
There are also many Hadith especially in the sahili category
which are very relevant and serve as guidelines to Islamic banking
system. Among the most important Hadith are the ones that forbid
the taking of riba. Apart from that, there are also man}’ other Hadith
in the areas of sales, salam (sale in which a price is paid for goods
to be delivered later); renting, hiwalah (transfer of a debt from one
person to another); representation; lending; payment of loans;
freezing of property; bankruptcy; partnership; mortgaging; witnesses
and conditions of transactions. These Hadith are an important
source of reference for Islamic banks in their daily operations.
The concepts of ijma and qiyas are becoming increasingly
important in formulating new Syariah laws in today's modem
business world, especially in finance and banking. These concepts
should be taken seriously by Islamic scholars and jurists due to four
main reasons. The first reason is based on the concept of Syariah itself
which contains issues of legislation and religion Matters related to
religion are based on spiritual experience. Belief in Allah (s.w.t.) and
the Prophet (p.b.u.h.) and other aspects involving belief and faith
(intan) are not exchangeable. However, matters involving legislation
are based on needs and desires of sodely as stated through laws
passed by the government or other law-making authorities. Laws
 LAWS ANU KIF.ULATIONS OF ISLAMIC BANKING 247

differ between countries and periods. According to Fyzee (1982),

laws can never be permanently static because only non-living
things are static. The changes that take place are the results of man's
control over situations, their vieyvs and perceptions about life, and
their desire to improve their living status. Many believe that what
have been established should be adhered to and not be amended.
However, this statement is something which should be re-evaluated
and its truth re-examined. This echoes Allah's (s.w.t.) words in Surah
Ali-lmrmt, verse 7 (Q3:7). This verse can be interpreted to mean that
laws can be changed, while matters related to religion are eternal
and are not amendable.
Secondly, Islam has already set a very high ethical goal which
requires each of its followers to achieve the standard it has set.
Every regulation and legislation formulated is something that
approaches the level of perfection. Islam also encourages its
followers to determine the essentials that they need to have in
life in order to reach that level of perfection. Once the essentials
have been determined then the method to achieve them must be
provided based on current situations. All this proves that Islam
is unambiguous and easy to understand; and has the capacity
to be constantly renewed and revived, fitting to the time and
situation.
The third reason lies on the basis of what had occurred during
the time of the Prophet (p.b.u.h.). During this period, the laws
available, through the Quran or the Prophet’s (p.b.u.h.) Sunnah
were only civil laws which were much needed by the society then.
The regulations and legislation were minimal and what were given
illustrate that Islam outlines the necessary guidelines fitting to the
situations. This clearly implies that Islam prefers or encourages its
followers to seek methods for resolving issues that are apt to the
time and situation at hand. In doing so, the Muslim ummah will
continuously increase and expand their knowledge, and use their
expertise and intelligence. All these actions and practices would
eventually benefit the whole of the Muslim ummah.
248 CHArtr.K 5

The fourth reason which makes it possible for the concepts of

ijma and qiyas to become increasingly important in shaping Syariah
legislation is seen through the lessons learnt from the teachings of
the Prophet (p.b.u.h.). Mahmasni (1982) believed that the teachings
of the Prophet (p.b.u.h.) do not restrain the Muslim ummah except
in matters related to religion, moral and other matters associated
with them. He further argued that Muslims are not obligated to
follow the Hadith on the opinions of the Prophet (p.b.u.h.) related
to everyday living. To back his view, Mahmasni extracted a Hadith
which reported the Prophet (p.b.u.h.) to have passed an orchard,
where several people were conducting pollination on date palms,
and the Prophet (p.b.u.h.) asked: "What are the people doing?" Upon
being told what the farmers were doing, the Prophet (p.b.u.h.)
said: “If they don't do it, the plants will flourish." On hearing this, the
farmers left their task and as a result the dates did not ripen. When
the Prophet (p.b.u.h.) was told of this outcome, he said:

/ am hut an ordinary man; if I instruct you to perform anything related

to religion, you are obligated to confirm to it. However. if 1 ask you to
do something based on my opinion. I am but human. Yon have better
knowledge in matters related to your living.
(Mahmasani, 1982, p. 186)

Based on the above Hadith, some are of the views that there is no
connection between Islam and everyday living except in matters
of religion. Issues of religion cover matters of belief and faith,
practices to enhance belief and faith, as well as moral principles
and regulations, and legislative basis for certain actions.
In conclusion, the role played by ijma and qiyas is to specify,
whether in terms of theory or practice, legislative issues related
to the actions of Muslims and at the same time make known the
commands stipulated bv the Quran and Hadith. In other words,
both these sources have the role of dalil sharia or evidence of Syariah
in matters of mualamat, without touching issues of ibadat or i tikadat.
Nuwayhi (1982) stated that there are groups who are highly fanatic
 LAWS AND REGULATIONS Of ISLAMIC BANKING 249

with their views that the Quran, Haiiilh and all the four mazaahib
have already projected and provided answers to every issue that
exists in modern legislation and regulations. This view in actuality
demonstrates two facets of ignorance. First, it shows their ignorance
in modem legislation which is filled with a range of aspects, of very
wide coverage and of varied interpretations. Secondly, they are
ignorant of the fact that Islamic legislative system itself took a long
time to develop and that it passed through various processes based
on needs and situations.
Nevertheless, Syariah law must comply with certain fundamental
principles. Doi (1984) stated that the basis of Syariah principles may
be summarized as follows:

(i) Interest of society is of higher priority compared to individual

interest.

(ii) Although both overcoming suffering and encouraging profit

or benefit are the foremost objectives of Syariah, overcoming
suffering is given more importance.

(iii) A big loss cannot be tolerated with the intention to avoid a

small loss, or a big profit cannot be sacrificed for the sake
of obtaining a small profit. Similarly, a small loss may be
accepted in order to avoid a bigger loss, or a small profit may
be sacrificed for file sake of obtaining a bigger profit.

SPECIFIC SYARIAH LAWS RELATED TO

ISLAMIC BANKING SYSTEM

In reality, no Muslim country has yet to formulate a law founded

on Syariah for its banking system. This is due to the fact that the
ones formulating laws are people, and these people would look
at it from the perspective of current situations. So eventually the
250 ciiatiirS

law formulated becomes positive law or man-made law. Although

formulating a complete set of Syariah laws for Islamic banking has
a long way to go, it is something that must be done continuously.
Among the earliest systematic Syariah law related to muamalat or
business is MajAllali s.w.t. el-Ahkam-I-Adliya or more commonly
known as The Mejelle. These laws were developed during the period
between 1869 and 1876 upon the wish of the Uthmaniyvah Sultan of
Turkey who had wanted to implement a process of renewal called
Tanzimat or restructuring. This legislation was to replace the Penal
Code of 1850 and Commercial Code of 1861 which were created based
on European laws. The formulation efforts were carried out by the
Legislative Commission headed by Ahmad Djevdet Pasha who
was the Minister of Justice at that time. On completion. The Mejelle
contained 16 books (or parts) and 1,851 articles. Only the tirst 12
books had relevance to business, while the last four books (books 13
to 16) were related to matters of procedure and evidencing in court.
The introduction or mukkaddime had 100 articles which functioned
as a guide to judges and lawyers in making decisions or providing
views on a matter being discussed. The books in The Mejelle which
had relevance to business are as follows:

• Book 1 (7 chapters): Sale and purchase (‘bai)

• Book 2 (8 chapters): Rent/hire (ijarah)

• Book 3 (3 chapters): Security/guarantee (kafalah)

• Book 4 (2 chapters): Transfer of debt (hiwalah)

• Book 5 (4 chapters): l’awn/lease (ralm)

• Book 6 (3 chapters): Trusteeship of property (emanet)

• Book 7 (2 chapters): Gilt (liibah)

• Book 8 (2 chapters): Breach of trust and destruction

• Book 9 (3 chapters): Restriction, compulsion and advancement

 LAWS ANU REGULATIONS OF ISLAMIC UANKING 251

• Book 10 (8 chapters): Corporatization and partnership

• Book 11 (3 chapters): Representative or agency (wakalah)

• Book 12 (4 chapters): Solution and release

Even though The Mejelle was certified by the Uthmaniyyah

Sultanate, the laws were not regarded as binding. This was because
the judges were free to make their own decisions. Eventually, on
17 February 1926, the Turkish government decided to use new
laws based on the Swiss Code and with that The Mejelle was no
longer applied. When Islamic banks were established, efforts
began in the search for Syariah which had relevance to the Islamic
banking system. Up until today, there is still no law formulated
specifically for this purpose, even if, at the very least, to match
The Mejelle. In fact, there is yet no publication that covers the
scope of what Syariah upholds, that is, development of laws with
considerations from the angles of the Quran. Hadith, ijma and qiyas.
Although there are several publicationsand writings of intellectuals
which touch on the issues of Syariah and Islamic banking, these
writings only touch the surface. One example is the writings of
Syafii Antonio, who tried to promote the basis of rules which are
related to the Syariah principles used. It is cited that, for instance,
the musyarakah principle has as its basis Surah an-Nisa, verse 12 and
Surah Shad, verse 24. Meanwhile, the Hadith which has relevance to
the musyarakah principle is the Hadith narrated by Abu Daud and
compiled by Hakeem in the book al-Buyu; and from the angle of
ijma it is the one from Ibnu Qudamah in the book al Mughni.
Apart from this, there are other literature which may be
regarded as initial efforts to promote Syariah in Islamic banking in
Malaysia. For example, Abdul Halim El-Muhammady in 2001 wrote
a general reading material titled Muamalat Laws & Their Applicufion
to Islamic Banking Products. Although it is not considered a law
book, the effort may pave the wav for more substantial literature
with various comparative sources. In addition to writings, there
252 CHATTER 5

are also publications of fatwa related to Islamic banking. These

include /atw by Fiqh Academy OlC,fatwa by the Syariah Advisory
of the Securities Commission of Malaysia and fatwa by the Fatwa
Council of Bank Muamalat Indonesia. Thesefatwa could be used as
the basis for ijma. Nevertheless, creating a comprehensive Syariah
law is not an easy task. The endeavour requires sacrifice from all
parties, especially the government. The aspects of Islamic banking
legislation required to be developed encompass the following:

• The relationship between the bank and its customers

(interpretation of a bank and customer, responsibility to be
fulfilled, contracts involved, customer as business partner, bank
as trustee, representative and chargee, etc.).

• The aspects of legislation underlying the products and services

offered by the bank to its customers (the tasks of receiving
money, cheque collection and payment, money order remittance
services within and out of the country, tasks related to travellers
cheques and foreign exchange).

• The aspects of legislation related to customers and the types of

customers (types of customers, accounts which could be opened
by customers, closure and methods of account management).

• Duties and responsibilities of the bank as issuer and collector

of customers’ funds (the processes of cheque cashing, cheque
collection, responsibility to pay or return the cheque which has
been cashed, negotiation and assigning a value to a cheque).

• Legal action on customers (the right to take action, when the

action can be taken and method of action, process of securities
sale and dissolution).

• Aspects of financing (business that could be financed, form of

financing and amount, properties that could be accepted as
securities and the process of approving the securities).
 LAWS AND REGULATIONS Of ISLAMIC RANKING 253

• Aspects of guarantee and representatives (the rights of

guarantors and representatives, responsibilities that must be
fulfilled, release of responsibility and compensation claims,
if any).

POSITIVE LAWS AND REGULATIONS

Basically, there is no uniform law to be followed by Islamic banks

throughout the world. In most Islamic countries, special laws are
formulated and passed prior to the establishment of the Islamic
bank. These laws would normally specify the rules and regulations
to be followed by institu lions wishing to engage in banking business
based on Islamic principles. The laws created are at times general in
form, meant for the monitoring of all the Islamic banks in a country,
and then there are also laws which are specific. The specific laws
are usually created to meet the needs of a particular bank only, and
its jurisdiction does not cover all other Islamic banks.
In Malaysia, however, the Islamic Banking Act 1981 was passed
by Parliament prior to the establishment of Bank Islam Malaysia
Berhad and this Law applies to any Islamic banking institution
wishing to operate in Malaysia. The Law consists of eight parts as
follows:

(i) Short title, commencement, application and interpretation.

(ii) Provisions related to licensing.

(iii) Financial requirements and duties.

(iv) Matters related to ownership, control and management.

(v) Restrictions on business.

(vi) Powers of supervision and control.

254 CHATTER 5

(vii) Miscellaneous matters such as indemnity, priority of sight

and savings account liabilities and penalties on directors and
managers.

(viii) Provision for consequential amendments that need to be made

to other related Acts to enable Islamic banks to carry out their
operations.

In Turkey, the decision to allow Islamic banks to operate is contained

in the Decree 83/7506 issued in December 1983 and published in
the Official Gazette No. 18256 dated 19 December 1983. The decree
contains 17 articles and deals with the method and procedures
of the establishment of "Special Finance Houses", their activities
and liquidation, under the Protection of the Exchange Value of the
Turkish Currency Law No. 1567 and Decree No. 70 regarding banks.
More comprehensive rules and regulations for Islamic banks were
formulated by the Undersecretariat of the Treasury and Foreign
Trade and published in the Official Gazette No. 18232 on 25 February
1984. In it are 35 articles covering the founding structure, operation
and liquidation of the Special Finance Houses. The decree also
covers matters such as the minimum amount of capital required
to set up a finance house and the types of accounts that the finance
house may offer to the public (Baldwin, 1990). Special Finance
Houses gained the "bank" status when the Banking Law No. 5411
was enacted in November 2005. Pursuant to this Law. Special
Finance Houses were renamed "Participation Banks". In Egypt, a
special act was passed for the purpose of establishing a particular
bank. Faisal Islamic Bank of Egypt for instance, was established
under the Special Act (No. 48) 1977. This Act outlines various
privileges for this bank and confers on it full authority beyond
any influence from government agencies, with the exception of
the central bank. Again, when the Islamic International Bank for
Investment and Development wanted to be incorporated in 1980,
a special ministerial decree was issued in accordance with the
Investment Law of Arab and Foreign Funds and Free Zones Law (No. 43)
 LAWS AND KEGUl ATIONS OF ISLAMIC HANKING 255

1974 (El-Ashker, 1990). In 2006, the Islamic International Bank for

Investment and Development was merged with the United Bank of
Egypt and Nile Bank to form a new entity called the United Bank.
In Jordan, the establishment of Jordan Islamic Bank was within
the ambit of the Temporary Special Law (No. 13) 1978. The enactment
of the Banking Law No. 28 of 2000 which was published in the Official
Gazette No. 4448 dated 1 August 2000 as amended by Temporary
Law No. 46 of 2003 and published in the Official Gazette No. 4600
dated 1 June 2003, outlines the definition of an Islamic bank, its
objectives, activities the bank may carry out and other conditions
and restrictions as imposed by the central bank. The Banking Law,
among others, states that the Islamic banks in Jordan may carry out
activities such as the following (www.cbj.gov.jo):

• Accept monetary deposits in various types of accounts including

credit accounts, mutual fund accounts or private investment
accounts.

• Issue Islamic bonds or sukuk.

Carry out finance and investment activities that are in accordance

with Syariah principles.

Carry out all traditional interest-free banking activities in

accordance with the law and regulations as set out and permitted
by the Central Bank of Jordan.

In Kuwait, a special government decree which recognized the

Islamic nature of banking was passed by the government before the
establishment of Kuwait Finance House on 23 March 1977 (Wilson,
1990). With the amendment of the Central Bank of Kuwait Law
(Act No. 32/1968} in 2003, Islamic banks in Kuwait are now regulated
by the Central Bank of Kuwait. The Law provides the regulatory
and supervisory framework for Islamic banking as well as the
framework for Syariah governance. Under Article 93 of the Law,
Islamic banks in Kuwait are required to establish an independent
Syariah Supervisory Board when applying for registration.
256 CHATICK 5

However, the Board reports directly to the Ministry of Awqaf and

Islamic Affairs, and not the Central Bank.
Although both Iran and Pakistan have converted their entire
banking system to the Islamic banking system, there are no
similarities in the banking laws in these two countries. In Iran,
as a result of the revolution in 1979, the banking system was
nationalized and the Law for Usury-Free Banking was passed
in parliament in August 1983. This Law is broadly divided
into four chapters: (i) Aims and duties of the banking system;
(ii) The mobilization of monetary resources; (iii) The granting of
facilities; and (iv) The Central Bank of the Islamic Republic of Iran
and the monetary policies (Herdavati, 1993). Although Iran has
introduced a specific law for the Islamic banking system, it does not
mean that all previous laws which regulated the banking system
are no longer operative. Instead, all provisions in the Money and
Banking Law 1972 which do not violate the principles set forth in the
new law remain effective (Shojaeddini, 1993).
Unlike Iran, Pakistan does not have a comprehensive single
law which deals with Islamic banks. Tile process of Islamization of
the whole banking system was done gradually and the rules and
regulations on this matter are given on a continuing basis. The rules
and regulations are usually issued in the form of declarations made
by the Finance Minister and circulars issued by the State Bank of
Pakistan. For example. BCD Circular No: 13 issued by the State Bank
of Pakistan in 1984 calls for the elimination of riba from the banking
system. A similar instruction was given to the deposit facilities. The
permissible modes of financing together with the possible modes
of financing for various transactions were also given in this circular
(Siddique, 1985). The Finance Minister also made an announcement
about Mudharabah Companies and Mudharabah (Floating and Control)
Ordinance on 26 June 1980. In January 1981 another announcement
was made on Mudharabah Companies and Mudharabah Rules 1981
(Gieraths, 1990). However, the procedure adopted by banks in
Pakistan since the country pursued its Islamization process in 1985
 LAWS ANO REGULATIONS Of ISLAMIC BANKING 257

was declared un-Islamic by the Federal Shariat Court in November

1991. Subsequently, laws involving interest which were introduced
since 1985 were declared invalid and ceased to have effect as from
1 July 1992. This decision was upjield by the Supreme Court of
Pakistan in December 1999. In response to this development, the
State Bank of Pakistan issued detailed criteria for setting up Islamic
banks in December 2001. In September 2002, Section 23 of the Banking
Companies Act 1962 was amended in order to allow Islamic banks
to establish Islamic banking subsidiaries. In January 2003, the State
Bank of Pakistan issued BPD Circular No. 01 which outlines detailed
policies for the promotion of Islamic banking in the country. Among
Others, the Circular contained guidelines for the establishment
of subsidiaries and stand-alone branches for Islamic banking by
existing commercial banks. In September of the same year, the
State Bank of Pakistan established an Islamic Banking Department
with the task of promoting and developing Islamic banking in the
country. Presently, Islamic banks in Pakistan operate under the
existing laws and regulations of conventional banks.
Initially, Indonesia did not have a specific law governing the
operations of its Syariah banks. When Bank Muamalat Indonesia,
the first Islamic bank in Indonesia, was established on I November
1991 and began operations on 1 May 1992, there was no specific
law that governed its operations. Instead, the establishment and
operations of this bank were within the ambit of Undang-Undang
No. 7, 1992, which regulates the banking system in Indonesia. This
Law provides no special provision that details the rules and aspects
related to Syariah banking operations, except for Fasal 13C (Clause
13C). However, this Clause only mentions them in the form of a
general statement in connection with People's Credit Banks which
could provide financing services based on the principle of bagi
basil (division of income) or the concept of profit and loss sharing,
according to what had been determined by the authorities (Antonio,
1999). In line with the efforts of the Indonesian government to
expand Islamic banking system in Indonesia, Undang-Undang
258 chapter5

No. 7, 1992 was amended to become Undang-Undang No. 10, 1998

which contains many provisions that are relevant to Syariah banking
system. These provisions include permission for commercial banks
and People’s Credit Banks to offer Islamic banking products.
The Law also details the Syariah principles to be used for banking
facilities and financing. However, since the year 2000, the
Indonesian government, through its central bank. Bank Indonesia,
has taken steps to develop a specific law for its Islamic banking
system. In June 2008, the Indonesian Parliament passed the Islamic
banking bill into law. The Indonesia Law No. 21 of 2008 on Islamic
Banking includes a provision for the establishment of new Syariah
banks jointly by foreigners and Indonesian citizens or local entities.
It also gives commercial banks the option to convert their operations
into Synnii/i-compliant banks. Aside from this Law, Islamic banking
industry in the country is also based on the rulings of the Central
Bank of Indonesia.
Not all Islamic banks have gained their footing through
supportive state intervention. Some Islamic banks encountered
various obstacles either at the initial stage of their establishment or
after they began operations. For instance, banks in Sudan are laden
with problems related Io regulations. In the beginning, these banks
were exempted from a number of banking regulations, but these
privileges were withdrawn after the government which wanted
to Islamized the banking system was overthrown in the year 1985
(Ahmed, 1990). Islamic banks in the United Kingdom are also
faced with various difficult issues which hinder their development.
The Bank of England does not regard Islamic banks as
deposit-taking institutions and therefore hinders their development
(Temple, 1992). Unlike other countries, the United Kingdom does
not have any specific law to govern the operations of Islamic banks
in the country. Islamic banks there are governed by the Financial
Services Authority (FSA).
Although most Islamic countries have enacted special laws
governing the operations of Islamic banks, this does not mean that
 LAWS AND REGULATIONS Of ISLAMIC BANKING 259

Islamic banks are subject to that particular law. As an ordinary

business entity, every Islamic bank is expected to follow the laws
and regulations relevant to other business entities or laws related
to activities which Islamic banks jntend to perform. For example,
Islamic banks in Iran are required to comply with the Law for
Usury-Free Bunking 1983 and are also subject to the provisions
found in Money and Banking Late 1972.
A similar situation is found in Malaysia. Islamic banks in Malaysia
need to comply with provisions under the Islamic Banking Act 1983.
In addition, since these banks are incorporated as public limited
companies, they are within the ambit of the Companies Act 1965.
The requirements which Islamic banks must adhere to cover issues
such as the appointment of director, appointment of auditor, notice
of meeting and other provisions. The requirement to comply with
these regulations is clearly provided for in Section 55 of the Islamic
Banking Act 1983. This section states that Islamic banks established
under the Companies Act 1965 are required to comply with this Act
apart from complying with the Islamic Banking Act 1983. In the event
that conflict exists between these two Acts, then the Islamic Banking
Act 1983 would take precedence over the Companies Act 1965.
Apart from this, one of the important elements related to
Islamic banking system in Malaysia is jurisdiction of legislation.
Even though Islamic bank is an organization founded on Islam,
all its business transactions are under the jurisdiction of the civil
court. Hence, any legal proceedings between Islamic bank and
its customers are to be handled by the civil court and not the
Syariah court. Nevertheless, efforts have been made by various
parties, including the Central Bank of Malaysia and the office of
the Attorney General to study how the Syariah banking legislation
could be developed in the interest of the Islamic religion. As a start,
a high court judge has been appointed as a member of the National
Syariah Supervising Board.
The legislative scope and authorities which govern Bank Islam
Malaysia Berhad (BIMB) are shown in Table 5-1.
260 CKAPTKK 5

TABLE 5-1 Legislative Scope and Authorities of BIMB

Activity Authority Act/Regulation

1. Establishment Company registrar Companies Act 1965

2, Management Shareholders memorandum
Board of Directors & articles of
Management association
committee Islamic Banking Act
1983
3. Licensing and Finance Ministry Islamic Banking Act
supervision Bank Negara 1983
Malaysia
4. Operation Relevant Syariah regulations
authorities Other laws
5. Syariah Religious Syariah regulations
supervision Supervision
Council

Involvement of the Central Bank

Some of the traditional objectives of the central bank in the
conventional banking system are to issue currency and to control
reserves in order to maintain the value of the currency issued, to
establish sound financial policies, to form stable policies of credit and
banking, and to be financial advisor and banker to the government.
These objectives may, however, vary from country to country, and
are dependent upon and influenced bv several factors. Among
the factors that play a big role in determining these objectives are
the political, economic and social condition of the countiry. Other
countries have included objectives in accordance with their current
and future needs. Tile Central Bank of Malaysia, for example, apart
from having traditional objectives, was instrumental in assisting
 LAWS AND REGULATIONS OF ISLAMIC BANKING 261

the government to produce a financial policy that is auxiliary for

the country' to achieve the objectives set out in the New Economic
Policy and Vision 2020.
In line with the aforementioned objectives, a country's central
bank is given the authority and responsibility through the law
to regulate and supervise the country's financial system. Hence,
Islamic banks being part of the financial system are also subject
to the regulation and supervision of the central bank. In fact, the
central bank has a function to play in the Islamic banking system
just as it does in the conventional banking system. This function
is also in line with the Syariah law, whereby Islamic banks are
accountable to those who are responsible for the financial affairs of
the country. To ensure the efficiency and effectiveness of the Islamic
banking system, especially in countries that practise both Islamic
and conventional systems, the central bank needs to play its role in
the following areas (Presley, 1988):

(i) Islamic banks in most countries face difficulty in competing

with conventional banks because they lack opportunity to
participate as an active player in the financial market, further,
Islamic banks are also at a disadvantage compared to their
counterparts when it comes to getting funds. Conventional
banks are able to obtain financial aid from other banks or
directly from the central bank when faced with liquidity
problems. Since the mechanism of the financial market uses
instruments based on interest, this assistance is inaccessible to
Islamic banks. Hence, the central bank should grant financial
aid to Islamic banks with liquidity problems by providing
Syuria/i-compliant instruments.

(ii) The central bank should expedite the process of establishing

financial instruments which are free from interest in order
to enable Islamic banks to fulfil their liquidity and statutory
reserve requirements. Islamic banks also need short-term
investment opportunities when faced with surplus liquidity.
262 CHAFTtK 5

An efficient and effective financial market for such financial

instruments could help to expedite the development and
increase the profit of the Islamic bank.

(iii) The existing laws in most Islamic countries are unsuitable for
Islamic banks to function fully. Hence, each Islamic country
should consider establishing banking laws that encompass
Islamic banking operations and are in accordance with Syariah
principles.

(iv) The central bank should set up a special department whose

responsibility is to oversee and supervise matters related to
the operations of Islamic banks, especially with regard to
newly-established Islamic banks or issuance of new products.

(v) Asuitable method must be presented to govern the relationship

between the Islamic banks and the central bank and other
financial authorities. Among the aspects required in this
relationship are:

• To explore suitable methods that would enable Islamic

banks to provide interest-free financing and refinancing
facilities.

• To seek out suitable methods for short-term investment

that would enable Islamic banks to invest their surplus
liquidity.

• Any facility or incentive given to customers of the

conventional bank must also be given to customers of the
Islamic bank.

There are many similarities in terms of powers vested in the

central banks of Muslim countries in regulating and supervising
Islamic banks. In Turkey for example, besides the special decree
passed by the Council of Ministers, the central bank has issued
rules governing the Islamic banks in the Official Gazette No. 18348
 IAWS ANI1 KIGllI.AIIONS Of IS1 AMIC HANKING 263

dated 21 March 1984. This regulation contains 18 provisions that

stipulate the requirements tor the application and issue of licences
to establish Islamic banks. The general outlines of some activities
of Islamic banks are also listed in this Gazette. An application to
operate an Islamic bank in Turkey will be scrutinized by the central
bank and the licence will be issued by the Council of Ministers
based on recommendations made by the central bank. The Central
Bank of Turkey is also responsible for determining the reserve and
liquidity ratios, and for conducting an audit on all the accounts and
operations of Islamic banks in Turkey (Baldwin, 1990).
In Malaysia, the Islamic Banking Act 1983 prescribes the powers
of the Central Bank of Malaysia over Islamic banks. Applications
to establish an Islamic bank in Malaysia must be forwarded to
tire central bank and it will scrutinize the application and make
recommendations for approval and rejection. The existing licence
of any Islamic bank may also be revoked on tire recommendation of
the central bank. Islamic banks in Malaysia must first seek approval
or report to the central bank regarding the following practices and
proposals:

(i) To open a new branch, agency or office within or outside

Malaysia.

(ii) To establish a corresponding banking relationship with any

bank outside Malaysia.

(iii) Proposed change in the control of the bank.

(iv) Whenever a loan or advance is made and secured in the

aggregate by 20% or more of the paid-up capital shares of
any other Islamic bank or of any licensed bank under the
Banking Act 1973 incorporated in Malaysia or of any finance
company licensed under the Finance Companies Act 1969.

(v) To grant advances, loan and credit facilities to its directors,

officers and employees.
264 cimptfr 5

(vi) In the case of the inability to meet its obligations or if the bank
is about to suspend payment.

(vii) Proposed amendment or alteration in the memorandum and

articles of association.

The Central Bank of Malaysia also has the power to conduct the
following tasks:

(i) Ensure the maintenance of paid-up capital and reserve funds

by the Islamic banks.

(ii) Establish the minimum amount of liquid assets to be held by

the Islamic banks at all times.

(iii) Specify the types and contents of reports to be submitted to

the central bank.

(iv) Prescribe the format of presentation and contents of the

financial statements prepared by the Islamic banks.

(v) Impose restrictions in relation to granting of advances, loans

and credit facilities.

(vi) Investigate and examine books, accounts and transactions of

the Islamic banks.

Although the central bank will continue to regulate and supervise

Islamic banks with various regulations and guidelines as with
conventional banks, a number of adjustments need to be made.
These adjustments are necessary particularly with respect to the
instruments or methods used in the monetary policies. Normally,
the central bank would use methods that could determine the
bank's liquidity amount which would in turn determine the bank’s
capacity to issue credit. Some of the method-, used are open market
operations, discounting concept and adjustments in reserve ratio
and liquidity requirement. Other methods include interest rate
policy, credit policy, credit limits and loan trend. The suitability of
 LAWS AND REGULATIONS Of ISLAMIC BANKING 265

the methods used depends largely on the political, economic and

social situation of a country.
Most of the policies used for conventional hanks are not suitable
for Islamic banks. Determination of interest rates and open market
operations are inappropriate because of the elements of interest
found in government securities and treasury bills. Hence, other
methods and instruments have to be developed to regulate the
role of Islamic banks in the determination of the national monetary
policy. Given that the role of Islamic banks in determining the
national credit trend is increasing, it is imperative for such a policy
to be developed. The Council of Islamic Ideology of Pakistan, in its
report on the elimination of interest from the economy, expressed
the view that most monetary policy instruments available to the
Central Bank of Pakistan under the various banking laws of the
country would also remain largely unaffected in an interest-free
system. Among the regulatory instruments that would remain
largely unaffected are as follows (Council of Islamic Ideology,
Pakistan, 1983):

(i) Minimum cash reserve requirement.

(ii) Liquidity ratio requirement.

(iii) Overall ceilings on the lending and investment operations of

banks.

(iv) Mandatory target for providing finance to priority sectors.

(v) Selective credit controls.

(vi) Issue of directions to banks on various aspects of banking

operations not covered by specific policy instruments.

(vii) Moral suasion.

Apart from the above methods, some Muslim countries have

included additional controls in their monetary policies involving
Islamic banks. Iran, for instance, as stated in Article 20 of tlie
266 CHATTFR 5

Law for Usury-Free Banking, empowered the Central Bank of Iran

to supervise money and banking affairs through the application of
the following instruments:

(i) Fixing a minimum and/or maximum share of profit for banks

in their joint-venture and mudharabah activities. This ratio may
vary’ for different fields of activities.

(ii) Designation of various fields for investments and partnerships

within the framework of the approved economic policies and
the fixing of a minimum expected rate of profits for various
investment and partnership projects. The minimum expected
rate of profit may vary with respect to different branches of
activities.

(iii) Fixing the minimum and maximum profit margins banks

could charge for instalment and hire purchase contracts.

(iv) Determining the types of services that the banks could provide,
and the fixing of minimum and maximum commissions banks
could charge for these services, and tire legal fees for managing
the investment deposits.

(v) Determination of the type and amount of minimum and

maximum bonuses under Article 6, and the fixing of criteria
for advertisements by banks in this respect.

(vi) Determining the minimum and maximum ratios of equitv

participation, mozarebeh, investment, hire purchase, instalment
transactions, buying and selling on credit, forward sales,
mozaraah, masaqat, jo'alah and gharz-al-hasaneh for banks and
in each one of the various cases and fields; and fixing the
maximum number of facilities that can be granted to any
single customer.

In Jordan, the central bank is empowered to regulate and supervise

Islamic banks as stated in Section 15, Chapter 5 of its Establishment
Laws, as follows:
 LAWS AND REGULATIONS OF ISLAMIC BANKING 267

(i) The bank may conduct any activity in various fields in

accordance with normal practices and regulations adopted by
commercial banks, except for activities which are in conflict
with the responsibility of the bank to avoid riba.

(ii) In conducting its banking activities, the bank Is bound by

al) restrictions imposed on commercial banks, including the
maintenance of cash reserve requirement, and specific liquidity
percentage to maintain a stable position and to protect the
interest of the depositors, investors and shareholders. The
bank will be subject to directives issued to it with respect to
the amount and types of credit, and the usage of credit, which
must be based on the country's development agenda

In Indonesia, apart from having the authority to control the banking

structure akin to most other central banks, Bank Indonesia,
the Central Bank of Indonesia, is also empowered under
Undaitg-Undang No. 10, 1998 to regulate general banks and rural
banks (People's Credit Banks) which operates Syariah banking.
Some of the terms are as follows:

(i) C/awse8(2)

The commercial bank is obligated to acquire and assimilate

financing and credit guidelines based on Syariah principles,
appropriate to the stipulations set by Bank Indonesia.

(ii) Clause 11 (1)

Bank Indonesia has to set the requirement on the maximum

credit limit or financing based on Syariah principles, provision
of guarantee, investment placement of letters of price, or other
similar matters, which can be employed by the bank to the
debtor or a group of related debtors, including to enterprises
in the same group as the bank in question.
268 chatter 5

(Hi) Clause 11 (3)

Bank Indonesia has to set the requirement on the maximum

credit limit or financing based on Syaria/i principles, provision
of guarantee, investment placement of letters of price, or other
similar matters, which can be employed by the bank to:

• Shareholders who own 10% or more of capital in the

banking sector;

• Board of Commissioners;

• Board of Directors;

• Family members to parties as meant in a, b and c above;

• Offices of other banks; and

• Enterprises in which all the above parties have interest

(iv) Clause 11 (4A)

In granting credit or financing based on Syariah principles,

the bank is prohibited from transgressing the maximum limit
of credit or financing based on Syariah principles as stated in
section (i), section (ii), section (iii) and section (iv).

Khan and Mirakhorf 1987) suggested that the central bank continues
its functions in determining the ratio for various types of liabilities
and the maximum amount of assets that can be distributed by the
Islamic bank in its partnership activities. Besides continuing to
regulate and supervise as in the conventional system, the central
bank may tighten its regulation over the Islamic banking system by
becoming a shareholder of Islamic banks as well as other financial
institutions. New opportunities would emerge if the central
bank participates with other banks in profit-sharing investments
and other joint ventures. However, this suggestion needs careful
consideration as such action may give rise to conflict of interest and
may cause central banks to deviate from their original objectives.
 LAWS ANO REGULATIONS Of ISLAMIC BANKING 269

In contrast to its early phase of establishment, Islamic banking

system is now regarded by most central banks to be an important
system in determining the direction of a country's financial system.
Consequently, a number of central banks have established special
departments that oversee and regulate the operations of Islamic
banks.

Syariah Supervisory Committee

Islamic banks are founded on religious factor. I ience, there need to

be a special body which ensures that the operations of the Islamic
banks do not violate any Synriali principles. In response to this, the
majority of Islamic banks have set up special bodies known as Syariah
Supervisory' Committee or Syariah Supervisory Board or Syariah
Monitoring Committee or Syariah Monitoring Board. This bod v issues
its report along with the annual report of the Islamic bank.
The Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI) based in Bahrain defines the Syariah
Supervisory Board as follows (AAOIFI, 2000):
The Syariah Supervisory Board is an independent body of
specialized jurists in fiqh almua'inalat (Islamic commercial
jurisprudence). However, the Syariah Supervisory Board
may include a member other than those specialized in fii/h
alniua'malai, but who should be an expert in the field of Islamic
financial institutions and with knowledge of fiqlt almtia'malaf.
This Board is entrusted with the duty of directing, reviewing
and supervising the activities of the Islamic financial institutions
in order to ensure that they are in compliana1 with Syariah rules
and principles. Thefatwa and rulings of the Syariah Supervisory
Board shall be binding on the Islamic financial institutions.
The name of the committee and total membership of the Syariah
Supervisory Board differ from one Islamic bank to another. These
are shown in Table 5-2.
270 CHAntK 5

TABLE 5-2 Syariah Supervisory Board Information

Total
Name of bank Name of committee
membership
Abu Dhabi Islamic Syariah Supervisory 5
Bank (1999) and Fatwa Board
Albaraka Islamic Syariah Supervisory 5
Bank, Bahrain (1998) Board
Bahrain Islamic Bank Religious Control 6
(1999) Committee
Bank Islam Malaysia Syariah Supervisory 5
(1999) Council
Bank Muamalat Dewan I’engawas 5
Indonesia (1999) Syariah
(Syariah Monitoring
Council)
Dubai Islamic Bank Syariah and Fatwa 4
(1999) Supervisory Panel
Faysal Islamic Bank Syariah Supervisory 6
of Bahrain (1999) Board
Faisal Islamic Bank of Syariah Supervisory- 4
Egypt (1998) Board
Islami Bank Syariah Council 10
Bangladesh
Jordan Islamic Bank Syariah Consultancy 3
Board
Kuwait Finance Syariah and Fatwa 4
House (1999) Supervisory' Board
Qatar Islamic Bank Syariah Control Board 4
(1998)

Sources: Annual reports of related banks for the years shown in table.
 LAWS ANI> REGULATIONS Ol ISLAMIC BANKING 271

Although the Accounting, Auditing and Governance Standards

for Islamic Financial Institutions issued by AAOIFI in June 2000
require all Islamic financial institutions to have their own Syariah
Supervisory Boards, it is possibly that some Islamic banks may
not have one. For example, Albaraka Bank in South Africa may
not have established this supervisory committee, since the
bank's annual statement does not contain any report from the
committee. Similarly with Tadamon Islamic Bank in Sudan. The
establishment article of this bank only requires a report issued
by the Fatwa and Research Administration of the bank itself, and
does not necessitate the need for a Syariah Supervisory Committee
(Annual Report, Tadamon Islamic Bank, 2002). When performing
its functions, this committee has the responsibility to ensure that
first, the banking facilities and services offered to customers are in
keeping with Syariah laws; secondly, the investments or projects in
which the bank has interest are permissible by Syariah; and finally,
the Islamic bank is managed according to Syariah principles. The
duties and responsibilities of this body become more challenging
if the bank concerned operates in a dual banking system, Islamic
and conventional. Hence, committee members must not only
possess in-depth knowledge in the field of Syariah but must also be
knowledgeable in the modern banking system. It is also essential
that members of this committee are unbiased, not easily influenced
by any authority and unafraid to stand up for the truth.
The setting up of Illis committee may vary from country to
country. In certain countries, there are provisions in the law that
require Islamic banks to establish Syariah committees. In Malaysia,
for instance, as stipulated in Section 5 of the Islamic Banking Act
1983, the central bank will not recommend the granting of a licence
to an Islamic bank unless it is satisfied that there is, in the articles of
association of the bank concerned, provision for the establishment
of a Syariah advisory board or committee. This committee in turn
has the responsibility to advise the bank on the operations of its
banking business in order to ensure that they do not involve any
272 CHAM l it 5

element that is not approved by the religion of Islam. In Jordan,

the establishment of this Syariali committee is stated in the Iordan
Islamic Bank for Finance and Investment Law. The provision and its
contents are stated below.

Section 27:

(i) The Board of Directors shall appoint, in a period of 15

days from the date of its selection, an Islamic legislation
consultant who is an acknowledged expert on Islamic
principles, laws and traditions.

(ii) The consultant appointed to this post cannot be dismissed

except on the basis of a board resolution adopted by a
two-third majority of the members at least, and the Board
giving grounds for such dismissal.

Section 28:

The Board of Directors shall determine the functions of the

aforesaid Islamic legal consultant on the basis that the Board
shall be under a duty to request the opinion of the Islamic legal
consultant regarding the following matters:

(i) Studying the practical regulations and rules applied by the

bank in its dealing with others, with a view to ensuring that
they do not contain any form of usurious dealings which
the bank is obligated to avoid.

(ii) Studying the causes which require the bank to bear any
investment loss, with a view to finding the legal doctrinal
(Hqlii} basis to support the resolution of the Board in this
regard.

I’he provision on the appointment of the consultative body is also

stated in the articles and memorandum of association of Kuwait
Finance House, Kuwait. In contrast to the provisions in the law of
Jordan Islamic Bank, provisions in Kuwait do not touch in detail
 I AWS AND REGULATIONS OF ISLAMIC HANKING 273

on the appointment of the Syariah Supervisory Board. Instead, the

law provides for the appointment of what is termed a consultative
body; provisions which are of relevance to this issue are shown
below.

Article 62:

The company shall retain consultative bodies specialized in

economics, financial and legal studies. Such specialized body
- or bodies - may be composed of a number of experts of
international repute. For certain specialities, the company may
retain only one expert or counsellor, but appointment of all such
experts and counsellors shall be effected by the decision of the
Board of Directors. The relationship between such appointees
and the company shall be limited to such studies as may be
assigned to them, and their researches and recommendations
shall be submitted either to the Chairman of the Board of
Directors or to such board members as may be delegated by the
Board for the purpose.

Article 63:

Consultative bodies, experts and individual consultants shall

basically execute their assignments in Kuwait. However,
consultation sessions may in special cases be held outside
Kuwait, under a decision to be issued by the Board of Directors
covering each and every case per se on the recommendation
of the Chairman or the Managing Director. In this respect, the
Board's decision shall specify the person who should represent
the Board of Directors at such session or sessions outside
Kuwait.

Article 64:

The Board of Directors shall, upon recommendation of the

Chairman or the Managing Director, determine the terms of
reference for the consultative bodies, experts and individual
274 <.H*rT>.K 5

consultants, whether their relationship with the company is

permanent or occasional. Moreover, the Board of Directors shall
lay down rules within the company's by-laws concerning such
activities and assignments.

In Egypt, Law No. 48 (1977) which allowed for the establishment

of Faisal Islamic Bank of Egypt also has provisions for matters
pertaining to the establishment of a monitoring body called the
Religious Supervisory Board.

Article 40:

The Supervisory Board shall be composed of no more than

five members selected from among Islamic scholars and jurists
of Comparative Law believing in the idea of the Islamic bank.
The general meeting shall appoint them every three years and
shall fix their remunerations upon the proposal of the Board of
Directors.
The task of the Supervisory Board shall be to offer advice
and undertake reviews as concern the application of the
provisions of the Islamic Si/ariah.
In this respect, it shall have the means and the competencies
available for the auditor.
The Board of Directors may invite a representative of the
Supervisory Board to attend any of its meetings but he shall
have no counted vote.
The Supervisory Board may request the holding of a special
meeting for the Board of Directors to explain its views on
matters of Syariah if it so deems necessary.
As an exception to the foregoing, the period of the first
Supervisory Board shall be four years.
Tile founders shall also select the members of the first
Supervisory Board immediately upon the promulgation and
publication of the Law and the Statutes.
 LAWS AND HI.CUI ADONS OL ISLAMIC BANKING 275

Article 41:

The Supervisory Board shall follow in its business and relations

with the management of the bank and its various components
the same means and shall Exercise the same competencies
according to the auditor under these Statutes.

Based on the standards issued by AAOIFI, matters related to

appointment, fixing of remuneration, composition, selection and
dismissal of this Board are as follows:

Appointment and Fixing of Remuneration

• Every Islamic financial institution is required to have a

Syariah Supervisory Board appointed by shareholders
in their annual meeting upon the recommendation of
the Board of Directors by taking into consideration local
legislation and regulations. Shareholders may empower
the Board of Directors to determine the allowance for the
members of the Syariah Supervisory Board.

• The Syariah Supervisory Board and the Islamic financial

institution should agree on the terms of engagement.
The terms agreed upon must be recorded in the letter of
appointment

• The Syariah Supervisor)' Board is required to ensure

that the Islamic financial institution documents and
confirms the Syariah Supervisory Board's acceptance of
appointment. The letter of appointment of the Syariah
Supervisor)’ Board should in general include reference
to the compliance of the Islamic financial institution with
Syariah rules and principles.

• The Syariah Supervisory Board may appoint those among

its members or other parties a supervisor(s) to help it in
performing its duties.
276 c IIAI'TI R 5

Composition, Selection and Dismissal

• The Syariah Supervisory Board shall comprise at least three

members. The Board may request the service of consultants
who have expertise in business, economics, law, accounting
and/or others. The Syariah Supervisory Board shall not have
the director or significant shareholders of Islamic financial
institutions as members,

• The dismissal of a member of the Syariah Supervisor)’ Board

requires recommendation by the Board of Directors and is
subject to the approval of the shareholders in the annual
general meeting.

The findings of the Syariah Supervisory Board on whether or

not the activities of the Islamic bank under its supervision are
Syarni/i-compliant are presented in the annual report of the
particular bank. How much is presented varies from bank to bank.
The reports provided by the Syariah Supervisory Boards of Bank
Islam Malaysia Berhad and Kuwait Finance House are rather brief.
They merely state that the operations implemented by the banks
conformed to Syariah rules. There are, however, some Syariah
Supervisory Boards, for instance those in Jordan, Bangladesh.
Dubai and Bahrain, which give detailed views on their activities as
well as the way they conduct their duties. In countries like Pakistan
and Iran, the establishment of such a body is unnecessary because
the government has a central body that gives a fatwa on banking
operations. Hence, unlike the annual reports of Islamic banks in
other countries, the annual reports of these banks do not contain
the Syariah Supervisory Board report.
AAOIFI recommends that each report of this committee has the
following basic elements:

• Title.

• Addressee.
 LAWS ANO REGULATIONS OF ISLAMIC BANKING 277

• Opening or introductory paragraph.

• Scope paragraph explaining the nature of the work performed.

• Opinion paragraph containing an expression of opinion on the

compliance of the Islamic financial institution with Syariah rules
and principles.

• Date of report.

• Signature of the members of the Syariah Supervisory Board.

The designated name of the committee suggests that only those who
are knowledgeable in Syariah law are competent to become board
members. Hence, the question arises as to whether those from other
fields and have expertise in Islamic banking may also qualify to be
appointed to the committee. Other issues pertain to some Islamic
scholars becoming a Syariah committee member of several Islamic
banks and financial institutions. Currently, the trend is for there to
be only one Syariah committee to supervise the operations of all the
Islamic banks in the particular country.

SUMMARY

As a business organization founded on religion and profit, an

Islamic bank is required to comply with two types of laws, that
is, Syariah laws and positive laws. Syariah law is an Islamic law
which covers the total way of life of Islamic organizations and
society that includes both faith and practices, personal behaviour,
and legal and social transactions. The aspects related to belief and
faith may be regarded as the theoretical aspects of Islam while the
practical aspects include all that a Muslim is required to do, that is
the practical course which he must follow.
278 tiiAi'it-K 5

There are five categories of principles in Syariah law that

control the behaviour of Muslims. The first is fard or compulsory
behaviour, where the actions involved are compulsory and must be
performed by all Muslims. Performance is rewarded and omission
is punishable and considered sinful. The second category is stinal.
which involves acts that are recommended but not required. Those
who perform such duties or acts are rewarded, but omission is not
punished. The third category, jaiz or mubah, refers to actions that
are indifferent, the performance or omission of which is neither
rewarded nor punishable. The fourth is makruh, and actions here
are those that are disapproved of but not punished or forbidden
Lastly, haram are actions that are forbidden and performing them
amounts to sinning.
There are four fundamental sources of Syariah laws, namely
the Quran, Hadith, ijma and tjiyas. The Quran contains the
commands and messages of Allah (s.w.t.) which were sent down
to Allah's Messenger (p.b.u.h.) as a guidance to mankind. Hadith
is the compilation of information, narration, history, accounts
and records of the Sunnah of the Prophet (p.b.u.h.), and signifies
the customs, habits and practices of the Prophet (p.b.u.h.), which
were handed down through generations. Hadith also describes
the Prophet's (p.b.u.h.) behaviour, modes of actions, sayings and
declarations under a variety of circumstances during his lifetime.
lyna is the consensus of opinion of mujtahid or an agreement of
Muslim jurists on the matter of determining a particular legislation,
while qiyas is the process of reasoning or the exercise of judgement
in both theological as well as legal matters by analogy of mu/tahid.
The Quran and authentic (sahih) Hadith are regarded as absolute
legislation and evidence whose truths are beyond question. The
Quran and Hadith are also known as wsuf or the roots. lima and
qiyas are branches of the Syariah law. Although these sources are
as a whole complete, a comprehensive Syariah law has yet to be
formulated to regulate and supervise the overall aspects of the
Islamic banking system.
 LAWS AND REGULATIONS OE ISLAMIC RANKING 279

Besides Syariah law, Islamic banks are also required to comply

with man-made laws called positive laws. In reality, there is no
uniform law to be followed by Islamic banks. It all depends on the
political climate and government,policies of the country in which
the bank is operating. Some countries have introduced specific
Islamic banking laws for Islamic banks, while others have passed
laws that must be complied with by all banks which are going to be
established in those countries. Apart from conforming to specific
laws, Islamic banks are also required to comply with other laws
related to the banking business.
Due to the fact that the banking sector is an important sector
of a country's economy, Islamic banks are also subject to the
monetary control and policy of the country. The task of regulating
and supervising Islamic banks is normally the responsibility of the
central bank. Generally, both conventional and Islamic banks are
governed by the same regulations pertaining Io supervision and
monitoring. However, the instruments which are related to the
practice of interest rates or riba cannot be used by Islamic banks.
Tile operations and businesses of Islamic banks are carried
out in accordance with Syariah principles. It is the duty and
responsibility of a special body known as the Syariah Supervisory
Board or Syariah Monitoring Council to ensure that the running
and operations of the Islamic bank do not violate any Syariah
principles, lire standards and functions of this board are issued by
the Accounting and Auditing Organization for Islamic Financial
Institutions centred in Manama, Bahrain. Nevertheless, variations
in terms of membership composition, method of appointment and
tasks conducted still exist. These differences become even more
apparent when different methods and contents are presented
in the annual reports issued by Syariah boards of Islamic banks
throughout the world.
280 CHATTER 5

REFERENCES AND FURTHER_READING

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Accounting and Auditing Organization for Islamic Financial

Institutions. Accounting, Auditing and Governance Standards for
Islamic Financial Institutions. Manama (Bahrain), 2000.

Ahmed, Osman. "Sudan: The Role of the Faisal Islamic Bank."

In Islamic Financial Markets, edited by Rodney Wilson, 76-99.
London (UK) and New York (USA): Routledge, 1990.

Albaraka Islamic Bank of Bahrain. Annual Report (various issues).

Ali, Abdullah Y. The Holy Quran, Text, Translation and Commentary.

Brentwood (Maryland, USA): Amana Corporation, 1989.

Ali, Maulana M. The Religion of Islam. Lahore (Pakistan): The

Ahntadiyyah Anjuman Ishaat Islam, 1950.

Antonio, Muhammad Svafi'i. Bank Syariah Bagi Bankir & Praktisi

Keuangan. Jakarta: Tazkia Institut, 1999.

Antonio, Muhammad Syafi’i. Bank Syariah: Suatu Pengenalan Umum.

Jakarta: Tazkia Institut, 1999.

Bahrain Islamic Bank. Annual Report (various issues).

Baldwin, David. "Turkey: Islamic Banking in a Secularist Context."

In Islamic Financial Markets, edited by Rodney Wilson, 171-189.
London (UK) and New York (USA): Routledge. 1940.

Bank Islam Malaysia Berhad. Annual Report (various issues).

Bank Muamalat Indonesia. Annual Report (various issues).

Centre Cultural Islamique. Introduction Io Islam. Paris, 1959.

Coulson, Noel J. History of Islamic Law. Edinburgh (UK): Edinburgh

University Press, 1964.
 LAWS ANO REGULATIONS <>E ISLAMIC BANKING 281

Council of Islamic Ideology (Pakistan). "Elimination of Interest

from the Economy." In Money and Banking in Islam, edited by
Ziauddin Ahmad, Munavvar Iqbal and M. Fahim Khan. Jeddah
(Saudi Arabia): International, Centre for Research in Islamic
Economics, King Abdul Aziz University, 1983.

Denny, Frederick M. An Introduction to Islam. New York (USA):

Macmillan Publishing Company, 1985.

Departemen Agama Republik Indonesia. Al-Quran dan

Ter/emaliannya. Jakarta, 1974.

Doi, Abdul Rahman I. Syariah: The Islamic Law. London (UK):

Ta Ha Publisher, 1984.

Dubai Islamic Bank. Annual Report (various issues). United Arab

Emirates.

El-Ashker. Ahmed. "Egypt: An Evaluation of the Major Islamic

Banks." In Islamic Financial Markets, edited by Rodney Wilson,
59-75. London (UK) and New York (USA): Routledge, 1990.

Faisal Islamic Bank of Egypt. Annual Report (various issues).

Faysal Islamic Bank of Bahrain. Annual Report (various issues).

Fyzee, Asaf A.A. "The Reinterpretation of Islam." In Islam in

Transition: Muslim Perspectives, edited by John J. Donohue and
John L. Esposito, 188-192. New York (USA) and Oxford (UK):
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C.ieraths, Christine. "Pakistan: Main Participants and Final Financial

Products of the Islamization Process." In Islamic Financial
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New York (USA): Routledge, 1990.

Government of Indonesia. Undang-Undang No. 10, 1998,

Undang-Undang Perbankan. Jakarta: Penerbit Sinar Grafika,
1998.
282 CHATTER 5

Guillaume, Alfred. Islam. 2nd ed. London (UK): Penguin Books,

1977.

Herdayati, Seyed Ali Asghar. "Islamic Banking, as Experienced

in the Islamic Republic of Iran." Working paper presented
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Islami Bank Bangladesh Limited. Annual Report (various issues).

Ismail, Abdul H. Bank Islam Malaysia Berhad: Principles and Operations.

Edited by Sheikh Ghazali Sheikh Abod, Syed Omar and Aidit
Ghazali. Kuala Lumpur: Quill Publications, 1992.

Jordan Islamic Bank. Annual Report (various issues),

Khan, Mohsin S. and Abbas Mirakhor (eds). Theoretical Studies in

Islamic Banking and Finance. Houston (Texas. USA): Institute for
Research and Islamic Studies, 1987,

Klein, F.A. The Religion of Islam. London (UK): Curzon Press, 1985.

Kuwait Finance House. Annual Report (various issues).

Lewis, Bernard, Menage V.L., Ch. Pellat and Schacht J.

The Encyclopedia of Islam (new edition). Leiden (Netherlands):
E.J. Brill, 1971.

Mahmasani, Subhi. "Adaptation of Islamic Jurisprudence to Modem

Social Needs." In Islam in Transition: Muslim Perspectives, edited
by John J. Donohue and John L. Esposito. 181-187. New York
(USA) and Oxford (UK): Oxford University Press, 1982.

Mannan, Muhammad A. Islamic Economics: Theory and Practice.

Cambridge (UK): Hodder and Stoughton. 1986.

Maududi, Abul Ala. Islamic Law and Constitution. Lahore (Pakistan):

Islamic Publication. 1983.
 LAWS AND REGULATIONS OF ISLAMIC BANKING 283

Nuwayhi, Muhammad. "A Revolution in Religious Thought."

In Islam in Transition: Muslim Perspectives, edited by John
J. Donohue and John L. Esposito, 160-168. New York (USA) and
Oxford (UK): Oxford University Press, 1982.

Presley, John R. (ed.). Directory of Islamic Financial Institutions.

London (UK): Croom Helm, 1988.

Qatar Islamic Bank. Annual Report (various issues).

Rahman, Fazlur. Islam. 2nd ed. Chicago (USA): The University of

Chicago Press, 1979.

Saleh, Nabil A. Unlawful Cain and Legitimate Profit in Islamic Law.

Cambridge (UK): Cambridge University Press, 1986.

Schacht, Joseph. An Introduction to Islamic Law. Oxford (UK):

The Clarendon Press, 1964.

Shallah, Ramadan. "Jordan: The Experience of the Jordan Islamic

Bank." In Islamic Financial Markets, edited by Rodney Wilson,
100-128. London (UK) and New York (USA): Routledge, 1990.

Shojaeddini, Mohammad Reza. "Instruments of Monetary Policy

in Islamic Banking." Working paper presented at the
International Conference on Islamic Banking, Sydney, Australia,
9-10 November 1993.

Siddiqi, Hamid, trans. Sahid Muslim. Vol 3. Beirut (Lebanon):

Dar al Arabia Publishing, Printing & Distribution, undated.

Siddiqi, Muhammad Iqbal. Model of an Islamic Bank. Lahore

(Pakistan): Kazi Publication, 1986.

Siddique, Muhammad. Islamic Banking System: Principles and

Practices. Islamabad (Pakistan): Research Associates, 1985.

Tadamon Islamic Bank. Annual Report (various issues). Sudan.

284 CHAPTER 5

Temple, Peter. "Islamic Banking: Principle as Well as Roots."

Accountancy. Vol. 110, Iss. 1187 (July 1992): 46-47.

The Me/elle: Being an English translation of Majallah el-Ahkam and

a Complete Code on Islamic Civil Law, translated by C.R. Tyser,
D.G. Demetriades and 1.11. Effendi. Kuala Lumpur: The Other
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Wilson, Rodney. "Kuwait: Islamic Banking for a Consumer Society."

In Islamic Financial Markets, edited by Rodney Wilson, 100-128.
London (UK) and New York (USA): Routledge, 1990.

Zakaria, Rafiq. The Struggle Within Islam: The Conflict Between Religion
and Politics. New York (USA): Penguin Books, 1989.
 CHAPTER

OPERATIONAL ASPECTS
AND PRACTICES OF ISLAMIC
BANKING SYSTEM

This chapter discusses the operational aspects and practices of a number

of Islamic banks. The discussion includes comparisons of the Syariah
principles governing the operations and practices of Islamic banks,
the services provided, investment, and social and welfare activities
among Islamic banks tn certain countries. The recommendations of the
Accounting and Auditing Organization for Islamic financial Institutions
for the presentation of accounts, financial management and presentation
of financial statements for Islamic banks are also detailed.

INTRODUCTION

Islamic banks are for Muslims who do not wish to have transactions
with conventional banks because of the presence of elements of riba
in their transactions. Hence, Islamic banks must make available
services similar to those provided by conventional banks. Further,

285
286 CHAPTER 6

the services should be portrayed as having better features than

those of conventional banks. By virtue of the fact that conventional
banks have been established in the world for some time already,
thev have various advantages over Islamic banks. The experience
and expertise that conventional banks possess enable them to not
only provide services which are efficient and comprehensive, but
also to realize the needs of customers and subsequently meet those
needs. As a result, conventional banks have the capacity to instil
loyalty in their customers, making it difficult for other financial
institutions to attract them.
The case is different with Islamic banks. The majority of
Islamic banks have only been in the market between 10 to 20 years.
In fact, a number of Islamic banks were only established in the
early 20th century. For instance, many Islamic banks in Indonesia
were established after the country suffered an economic crisis at
the end of the 1990s. Although these banks are still in their early
stage of development, most have successfully provided banking
services that are efficient and effective to their customers, and
nearly all have recorded profits. In addition to the increasing
trend in the level of yearly profits, other statistics also indicate an
increasing amount of deposits and financing. These data prove
that Islamic banks not only have managed to establish themselves
as a viable alternative to conventional banks but they have also
been able to improve themselves in terms of profitability and
patronage. Moreover, Islamic banks not only serve the needs of
Muslim customers; they have extended their operations to service
non-Muslims. For example, Bank Islam Malaysia Berhad (BIMB)
which began operations in 1984, as at the end of August 1993, had
350,000 customers of whom 17,000 were non-Muslims. By the end
of 2007, BIMB customers totalled more than one million whereby
about 10% were non-Muslims. Similarly, Bank Muamalat Malaysia
Berhad which started operations as a full-fledge Islamic bank at
the end of 1999 also recorded encouraging development. At the
end of 2006, around 10% of its customers were non-Muslims.
 OPERATIONAL ASPECTS AND PRACTICES OF ISLAMIC BANKINC. STS I EM 287

These figures prove that Islamic banks are accepted by both

Muslims and non-Muslims,
Apart from the successes of Islamic banks individually, the
Islamic banking system has clearly demonstrated its capability to
become a viable alternative to a country's economic management.
For example, when Iran and Pakistan Islamized their respective
financial systems, they received cynical views as to the viability
of it. Nevertheless, more than ten years after the implementation
of the Islamic system, there has been no indication that the
economies of these countries have declined. On the contrary, based
on the statistics issued by the International Monetary Fund, the
amount of deposits in both countries had increased. For example,
after the nationalization of its banking system, banks in Iran had
total deposits of IRR980.88 billion in the current account and
IRR1,776.74 billion in the fixed deposit and savings account
in 1980. (The currency of Iran is the Iranian Rial or IRR.)
These figures increased to 1RR2,864.9 billion for the current account
and IRR4.339.2 billion for the fixed deposit and savings account at
the end of 1986 and continued to increase to reach IRR7,850.9 billion
and 1RR13,341.6 billion for the current account and fixed deposit
and savings account, respectively at the end of 1991. The amount of
both types of deposits soared to IRR353,093.3 billion for the current
account and 1RR869.654.5 billion for the fixed deposit and savings
account at the end of 2007.
Similar trends were also observed in Pakistan. Although
some are of the view that Pakistan has not fully Islamized its
entire economic system, some of its banks did adopt the Islamic
economic system. At the end of 1980, the country's banking sector
recorded total deposits of Rs33,698 million and Rs30,650 million
in the current account and fixed deposit, respectively. (The official
currency of Pakistan is the rupee or Rs.) The amount of deposits in
Pakistan has continued to record a yearly increase. For example,
the amount of deposits in the current account was Rs69,103
million in 1985 and this increased to Rsl38,725 million in 1990,
Rs340,332 million in 1995 and Rs458,901 million in 2000. At the end
of June 2008, the total deposit in the current account had soared
to Rs965.4 billion. Fixed deposit was Rs82,091 million at the end
of 1985, and this figure increased to Rsl61,221 million in 1990,
Rs424,964 million in 1995 and Rs730,112 million in 2000.
Total amount of fixed deposit at the end of June 2008 was
Rsl.211.5 billion. Meanwhile, total deposit in the savings account
increased from Rs339,259 million in 1996 to Rs583,492 million in
2000. As al end of June 2008, the total deposit in the savings account
was Rsl,572.7 billion. Based on these data, it can be concluded that
the Islamic banking system is in fact practicable. The willingness of
non-Muslims to patronize Islamic banks proves that this system is
suitable for people of all races and religions.

APPLICATION OF SYARIAH PRINCIPLES

Chapter 3 has described the range of Syariah principles applied

by Islamic banks in providing their products and services to
their customers. Basically, the applications of these principles are
dependent on the following:

(i) If a country has policies for the development of an Islamic

bankingsystem, then the financial authorities such as the central
bank or other bodies will determine or suggest the principles
to be used by Islamic banks under their supervision.

(ii) If an Islamic bank operates in a country in which the central

bank is not concerned with the development of the Islamic
banking system, then the principles used will depend largely on
the discretion of the bank itself I lence, the types of principles
applied will be made known either through publications made
by the central bank (either as published articles or through its
website) or in the bank's annual report.
 OPERATIONAL ASPECTS ANTI PRACTICES OF ISLAMIC HAAKINX. SYSTEM 289

Differences in practices and interpretation of the principles

governing banking practices do occur among Islamic banks. A list
of Syariah principles adopted by various Islamic banks in selected
Muslim countries is given in Table 6-1.
Table 6-1 shows several obvious similarities and differences
in tile usage of Syariah principles among banks in Iran, Malaysia,
Pakistan, Bangladesh, Kuwait, Jordan, Bahrain, United Arab
Emirates and Turkey. As explained earlier, Syariah principles used
by Islamic banks may be classed into five categories, namely the
profit-loss sharing principles, sale-based principles, fees-based
or charges-based principles, free service principles and ancillary
principles. The following are some of the similarities and differences:

1. Malaysia is the only country where Arabic words are used in

describing all Syariah principles governing Islamic banking
operations. Other countries, however, retain Arabic words for
certain principles only and use vernacular words for others.
Some of the Arabic words which are commonly used by almost
all Islamic banks are mudharabah, musyarakah, murabahah, ijarah
and qard hassan.

2. Although there are slight differences in spelling and

pronunciation for a number of principles, they are basically
the same. For instance, the mudharabah principle: Iran uses
mozarebeh, Malaysia formerly called ital-mudharabah but now it is
known as mudharabah, Bangladesh calls it al-mudaraba, Pakistan
and Bahrain use modaraba, Kuwait and Jordan use mudaraba
and Sudan calls it mudarabat. Differences in spelling and
pronunciation also occur for other principles like musyarakah,
ijarah and yard hassan. Turkey does not use Arabic terminologies
for its principles.

3. Within the category of profit-loss sharing, most countries

practise two principles, namely mudharabah and musyarakah,
while Iran has more than two principles. The musyarakah
T A B L E 6 - 1 S y a r ia h P r in c ip le s U s e d b y I s la m ic B a n k s
290
CHArim6

adle » -i K onnnuecu

i
*

S o u rces: Iran: T h e L a w F or U su ry -F re e B a n k in g 1 9 8 3 ; M a la y sia : w w w .b n m .g o v .m y ; P a k ista n : S ta te B a n k o f P a k ista n , B C D C ircu la r

\ | 13, 2 0 J u n e 1984; B a n g la d e sh : A n n u a l R ep o rt, Isla n ii B a n k B a n g la d e sh L im ite d , 2 0 0 7 ; K u w a it A n n u a l R ep o rt, K u w a it
OPERATIONAL ASPECTS ANO PRACTICES OF ISLAMIC HANKING SYSTEM

F in a n c e F lo u s e , 2 0 0 7 ; J o rd a n : A n n u a l R ep o rt, J o r d a n Isla m ic B a n k . 2 0 0 7 ; B a h ra in : A n n u a l R ep o rt, S h a m il B a n k o f B a h ra in

(fo r m e r ly k n o w n a s F a y sa l Isla m ic B a n k o f B a h r a in ). 2 0 0 7 ; T u rk ey : A n n u a l R ep o rt, T u r k iy e F in a n s, 2 0 0 7 ; U n ite d A ra b
291

E m ir a te s: A n n u a l R e p o rt, D u b a i Isla m ic B a n k , 2 0 0 7 ; In d o n e sia : A n n u a l R ep o rt, B a n k .M u a m a la t I n d o n e s ia , 2 0 0 7 .

292 CHArrrnft

principle can be divided into two, that is, (i) permanent

musyarakah and (ii) diminishing musyarakah. Permanent
musyarakah, or commonly simply referred to as musyarakah, is a
situation where the bank participates in the equity of a company
without fixing the date of termination of its participation. The
returns acquired are usually based on the capital contributed.
Diminishing musyarakah or commonly known as musyarakah
mutanaqissah, exists when the bank agrees to transfer gradually
its share to the other shareholders, so that the bank's share
declines and the other shareholders' share increases until
eventually the company would be fully owned by the latter.

4. Iran has three additional principles, namely civil partnership,

legal partnership and direct investment, but all these principles
are based on the principle of profit-loss sharing. The principle
of civil partnership operates on the contribution of cash and
non-cash capital by several individuals or business to a
common pool on a joint-ownership basis. The partnership
will be terminated as soon as the project is completed. Legal
partnership involves partnership between individuals or
with other entities to form a new business entity or company,
where each individual involved becomes the shareholder.
Direct investment occurs when the investor directly invests or
provides additional capital for productive projects.
5. Pakistan, as with Iran, also has various principles within
the profit-loss sharing category. Principles such as equity
participation, purchase of shares, participation term certificate,
modaraba certificate and rent sharing are those used by banks in
that country to channel money to customers in need of financial
aid. The returns are determined by the profitability of the
issuing company. Participation term certificates are transferable
financial instrument issued by a company for a specific period
and are secured by a legal mortgage on the fixed assets of
the company. Modaraba certificate is a certificate issued by
OPERATIONAL ASPECTS AND PRACTICES OL ISLAMIC BANKING SVSTI M 293

companies which are registered under the Mudarabah (Floating

and Control) Ordinance 1980. Banks in Pakistan are allowed to
purchase the certificates and the investment is almost the same
as purchasing the shares of those companies except for the
fact that the owner does not have authority as a shareholder.
In rent sharing, the bank provides finance for the construction
of buildings, complexes, etc., and receives a share of the rental
income of the property. However, no information is available on
the use of the musyarakah principle by Islamic banks in Pakistan.
6, The principles in the sale and purchase category also differ
among banks. Malaysia has the most number of Syariah
principles in this category, that is, six principles, followed by
Bangladesh and Bahrain with four principles each. Islamic
banks in Turkey do not have any principles listed under this
category. Among the principles used by the majority of Islamic
banks in the world are murabahah, salam and istisna. Bahrain
uses a principle which is not used by banks anywhere else,
that is the tawarruq principle, a principle associated with the
financing of sale and purchase of items involving a third party.
Malaysia also practises several of its own principles, namely
bai al-inah, bai al-istijar and sarf. Bai al-istijar and sarfare also used
elsewhere. Bai al-istijar is a sale and purchase principle used in
Pakistan involving repeated deliveries. Sarf is a currency sale
and purchase contract.
7. The number and types of Syariah principles used in the category
of fees, commission and fixed charges also vary among Islamic
banks. Islamic banks in Indonesia do not state any principles
used in this category; however, in the 2003 annual reports of
Bank Muamalat Indonesia and Bank Syariah Mandiri, it was
mentioned that services based on fees and commission were
provided. Islamic banks in Jordan and Dubai list three principles
under this category; Jordan only uses murabahah, commission
and service charge, while the United Arab Emirates uses
murabahah. istisna and service charge. Islamic banks in Turkey,
294 CHATTER 6

Bahrain and Kuwait list five principles, namely murabahah,

commission, service charge, ijarah (lease for Kuwait) and ijara
wa-iqtina (istisna for Kuwait). Malaysia and Pakistan list six and
five principles respectively, while Bangladesh lists seven and
Iran five.
8. The number of Syariah principles used also differ among banks
for the category of fees and commission. Malaysia uses six
principles and Pakistan five. The principles used by almost all
Islamicbanks are ijarah and service charge. Among the principles
which are used by a particular country are jo'alah in Iran and ujr
in Malaysia, but there is actually not much difference between
these two principles and the ones used by other Islamic banks.
Both involve the undertaking of one party to pay a specified
amount of money to another party in return tor rendering a
specified service in accordance with the terms of the contract.
Hence, this principle is similar to the concept of service charge
used by other Islamic banks.

9. Tlie principle of bai muazzal used in Bangladesh is the same as the

principle of bai bithaman ajil used in Malaysia and the principle
of instalment sales used in Iran. Although these principles are
not listed by Islamic banks in Bahrain, Kuwait, Jordan, Turkey
and the United Arab Emirates, these banks actually do provide
instalment services to their customers by applying the murabahah
principle, known as bay-al-mudarabah.

10. Although Islamic banking in Pakistan and Malaysia seem to

have many Syariah principles for their commission and fixed
charges category, these principles can be brought together
with the principles of service charges. In Pakistan, for instance,
development charges and service charges are terms used in
imposing charges on customers. In Malaysia, on the other hand,
principles such as al-wakalah, al-kafalah, al-liiwalah and al-ujr are
terms representing the nature of services rendered to customers
and how these charges will be imposed on customers.
 OPERATIONAL ASPECTS AND PRACTICES Of ISLAMIC UANKINC SYSTEM 295

11- The qard hassan principle or free service loan is used widely by
the majority of Islamic banks. Only Iran and Kuwait use this
principle for deposit facilities; other banks use it for financing
facilities. Islamic banks in Sudan do not adopt this principle
at all.

12. There are principles that are used by Islamic banks in particular
countries only. Examples are jo'alah, inozaraah and masaqat
which are. used in Iran, and ar-rahn and al-wadiah yad dhamanah
which are used in Malaysia. Tire riilni principle is associated
with pawning. Although other Islamic banks do not mention
other ancillary principles, in practice they too require security
or guarantee when offering financing and investment services.

13. Turkey is the country’ that registers the least number of Syariah
principles used in its Islamic banking system. In fact, Islamic
banks in Turkey such as Turkiye Finans and Bank Asya do
not mention at all the Syariah principles that they adopt. They
merely state that the facilities available are based on profit
sharing. Nonetheless, these banks do provide a wide range of
banking services and products.

There are many reasons for the different terminologies and

principles used by Islamic banks in offering their services.
First, the Islamic banks are not governed bv a uniform law.
In Malaysia, for example, Islamic banks are subjected to laws related
to Islamic banks which have been approved by the Malaysian
government, while Islamic banks in other countries are subjected
to laws in their respective countries. Furthermore, every Muslim
country has its own religious authority which is responsible for
monitoring and supervising the activities of Islamic banks in that
country. The religiousauthority of a particularcountry isindependent
of the religious authorities of other countries. Hence, directives of
a particular law issued in a particular country are not applicable
to communities beyond its jurisdiction. Secondly, currently there
296 cuai-ter 6

is no organization or party that has the authority to monitor and

supervise the operations of all Islamic banks throughout the world.
Although there is an association called International Association of
Islamic Banks, this association does not have any legal hold on its
members. In fact, membership is on a voluntary basis. As a result,
each Islamic bank is free to choose the principles it wishes to adopt
and apply in its banking businesses.
The absence of a comprehensive list of Syariah principles used
by a particular Islamic bank may cause customers and financial
statement users to lack aclear understanding of the Syariah principles
underlying a particular transaction. This failure of the banks in
this matter is not done consciously. It is merely because there is
no legislative provision or standards which require them to do so.
The standards set by the Accounting and Auditing Organization
for Islamic Financial Institutions (AAOIFI) do not require Islamic
banks to provide such lists. Since Islamic banks have been in
operation for some time now, these banks may probably assume
that the public already has a clear understanding of the Syariah
principles adopted by them.

SERVICES PROVIDED BY ISLAMIC BANKS

As an institution which is involved in banking activities, it is only

appropriate that the Islamic bank should provide sen ices which
can meet the needs of a range of users. The users may be seen as
three main groups, that is, individuals, business organizations
and government bodies. The individual with excess money would
deposit his money in the bank for transactions, precautionary or
investment purposes. Businessmen hold monev for transactions
and investment purposes, while government do so for investment
motives. Individuals require financing from the bank for the
 OPERATIONAL ASPECTS AND PRACTICES OF ISI.A.MIC BANKING SYSTEM 297

purpose of meeting their investment and personal needs.

Businessmen require financing to either start or expand their
businesses. Financing required may be in the form of working
capita] and fixed capital financing. The government, meanwhile,
needs money to finance its budget deficit.
Islamic banks also offer other facilities. In addition to catering
to the needs of regular customers, the banks also provide services
needed by temporary clients. Temporary clients are those who
require banking services at certain times and for certain activities
only. Such services include letters of credit, letters of guarantee,
money order, foreign exchange, cheque and bank draft issuance,
advisor)- services, etc. Hence, services offered by Islamic banks may
be classified into three groups, namely deposit facilities, financing
facilities and other facilities.

Deposit Facilities
The following are some of the similarities and differences among
the deposit facilities provided by Islamic banks:

(i) Except for Turkey which offers only two types of deposit
facilities, namely special current account and participation
account, Islamic banks in other countries provide three types
of deposit facilities, that is, current account, savings account
and investment account.

(ii) There are some differences in the treatment of the savings

account facility among Islamic banks. Islamic banks in Iran,
Pakistan and the United Arab Emirates regard the savings
account as a facility by itself. On the other hand, Bangladesh,
Kuwait, Jordan and Bahrain consider it as one of the facilities
within the investment account. Malaysia and Indonesia offer
two types of savings account, that is, accounts using the wadiah
and mudharabah principles.
298 CHAFITH 6

(iii) In general, the investment account facility can be divided into

three categories. The first category is deposits based on time,
for example, tenure periods of three months, six months, nine
months, etc. The second is deposits based on notice, where
notice must be given by customers prior to any withdrawal.
The third is deposits for specified projects or purposes.
Investment deposit facilities based on notice are only available
in Bangladesh, Jordan and Bahrain. Specific investment
account is available in most countries except Iran, Kuwait,
Pakistan and Turkey. Apart from this, there are also investment
accounts with restrictions and investment accounts without
restrictions. For investment accounts with restrictions, the
bank cannot use the funds deposited by clients except in
accordance with the specifications provided. This is not the
case for investment accounts without restrictions.

(iv) Sometimes there are differences in terms of the Syariah

principles used and in the types of deposit facilities offered
among Islamic banks within the same country, as in the case of
Bahrain. For example, Shamil Bank of Bahrain offers two types
of deposit facilities, that is, demand deposit and investment
deposit or investment account. The demand deposit is of
two types, current account and savings account. Both these
accounts do not give out any returns and depositors can at any
time make withdrawals. Cheque books are given to the current
account holders while passbooks are given to the savings
account holders. Investment account is offered based on the
concept of trust and is offered based on time and notice. The
account holder will be given either a bank book or certificate
of deposit. Here, the bank will invest the deposit made by the
customers and the bank does not share in the profit acquired
from the investment. Instead, the bank charges its customers a
service fee. The deposit made according to this principle is not
considered a liability bv the bank and the amount is removed
from its balance sheet.
OrEBA1IO.N Al ASPECTS AND PRACTICES Ol ISLAMIC BANKING SYSTEM 299

Albaraka Islamic Bank of Bahrain also offers two types

of facilities, current account and investment account. The
operation of its current account is similar to those of other
banks while the investment account offered is based on
profit-loss sharing. In addition, this bank also manages its
customers’ funds, and customers can choose whether to invest
in specific funds or funds based on specific mudharabah. Islamic
Bank of Bahrain also offers two types of deposit facilities.
They are current account and investment account. Its current
account does not offer any returns, while its investment
account is based on profit-loss sharing.

(v) Differences exist in the Syariah principles used by Islamic banks

in their deposit facilities. For example, current accounts in Iran
and Kuwait use the qard hassan principle, while Islamic banks
in other countries use wadiah or trust. In the case of savings
account, Iran uses the qard hassan principle, while Kuwait
combines two principles, that is, the mudharabah principle
for savings account with permitted investment and the qard
hassan principle. In Malaysia, savings account is based on
al-wadiah yad dhamanah or guaranteed deposit. Islamic banks
in other countries use the profit-sharing or mudharabah
principle for their deposit facility. For investment account,
all Islamic banks use the mudharabah principle, except for
Shamil Bank of Bahrain which uses the wadiah concept.

(vi) Most banks provide a guarantee to return the full amount

of deposits placed by customers in deposit facilities except
in the profit-loss sharing facility. Islamic banks in Iran and
Malaysia provide some kind of returns to their savings account
customers. These rewards are solely based on the discretion
of the banks. Islamic banks in Iran do reward their current
account holders but the rewards are not fixed or guaranteed.
The rewards given may be in the form of cash bonus, air ticket
to Mecca, carpets, cars, etc. In Malaysia, the reward for savings
300 CHATTER 6

account holders is usually in the form of profit announced by

the bank.

(vii) In addition to providing services based on the country's local

currency, there are Islamic banks which accept time deposits
in foreign currencies. This type of facility is offered by Islamic
banks in Turkey and Jordan.

In terms of daily operations, there are some regulations and

procedures that must be adhered to by Islamic banks and their
customers. In most cases, the operational aspects and practices of
these deposit facilities are similar to that of conventional banks.
These similarities include the procedures and requirements such
as the minimum deposits for opening an account, identification,
method of closure and termination of operation, management of
unclaimed monies, etc.
Deposit facilities provided by Islamic banks in selected Muslim
countries are shown in Table 6-2.

Financing Facilities
Islamic banks also offer financing facilities to their customers.
Financing for businesses include short-term and long-term
financing. The former type of financing is usually for meeting
working capital requirement while long-term financing covers
capital expenditure or expenditure associated with long-term
projects. Financing facilities offered to individual customers include
financial aid in the form of housing and consumer goods loans
Since Islamic banks are prohibited from making loans other than
those based on the qard hassan principle, all financing operations
are either based on the profit-loss sharing principle or the principle
of fees, commission and fixed charges.
TABLE 6-2 Deposit Facilities Provided by Islamic Banks

A n n u a l R e p o rt. D u b a i Isla m ic B a n k . 2 0 0 7 ; I n d o n e s ia : A n n u a l
OPERATIONAL ASPECTS ANO PRACTICES Op ISLAMIC BANKING SYSTEM
301
302 CHATTER 6

There is no clear demarcation in terms of priority in the use

of principles when meeting the financing needs of customers, be
it corporate or commercial customers. However, the principles of
mudharabah and inusyarakah are widely used in financing working
capital loans while the principles of murabahah, bai muazzal and
ijarah are used to finance the purchase of fixed assets bv customers.
The financing principles used by Islamic banks depend a lot on the
law governing their operations. In Iran, for instance, modes and
scopes of financing facilities used are described in the Law of Usury-
Free Banking as shown in Table 6-3.

TABLE 6-3 Syariah Principles Associated with Financing

Facilities in Iran

Area Activity Syariah principle

Productive Industrial Instalment sale, civil
Agricultural partnership, legal partnership,
Mining hire purchase, forward
transaction, direct investment,
qard-al-hasanah, jo'alah,
mozaraah, masaqat
Commercial Import Modarabah, civil partnership,
Export legal partnership, jo'alah
Domestic
Services Civil partnership, legal
partnership, hire purchase,
instalment sale, jo’alah
Housing Construction Civil partnership, instalment
Repairs sale, hire purchase, qard-
al-hasanah, jo'alah, direct
investment
Personal Qard-al-hasanah
needs
 OPERATIONAL ASPECTS AND PRACTICES Ol ISLAMIC BANKING SYSTEM 303

hi Pakistan, the principles used are based on the Circular, Stale Bonk
of Pakistan No. 13 dated 20 June 1984. It contains a list of permissible
methods of financing, covering loans, trade and investment.
The guidelines cover various economic activities that could be
adopted by Islamic banks in Pakistan. The principle recommended
for project financing is associated with the profit-loss sharing
method. The minimum and maximum rates of returns that may be
acquired from any principle used for trade activities and the profit
rates for investment activities are pre-determined by the State Bank
of Pakistan from time to time. Meanwhile, should the investment
activity result in a loss, the loss is borne by all the financiers.
In Malaysia, Islamic banks provide their corporate customers
financing to meet working capital requirements and this project
financing is based on the principles of mudharabah, musyarakah,
murabahah, bai muazzal and ijarah. For the commercial customers,
the banks provide personal financing for acquisition of houses,
buildings, consumer goods and others. This financing is based
on the principles of bai muazzal and yard hassan. Principles used
by Islamic banks in Bangladesh are very similar to those adhered
to by Islamic banks in Malaysia, but the banks in Bangladesh
have an additional principle, namely the bai-salam principle.
Overall, most of the Syariah principles used by Islamic banks are
based on mudharabah, musyarakah, murabahah, bai muazzal, ijarah
and yard hassan. However, Islamic banks differ in the priority of
principles used and the extent to which particular principles are used
depends a lot on the management of that particular Islamic bank.
The financing activities of Islamic banks in selected countries
based on Syariah principles are shown in Table 6-4. Referring to
Table 6-4, there exist several similarities and differences among
Islamic banks in providing financing to clients. The following are
some of the more obvious similarities and differences:

(i) Although the principles of mudharabah and musyarakah

(profit-loss sharing) are recommended by Islamic scholars,
there are still some Islamic banks which do not apply these
304 CHAntR 6

principles while others channel a very small portion of their

funds into these modes of financing. For instance, in their
annual reports, Kuwait Finance House and Albaraka Turk.
Turkey, did not show any record of financing based on the
principles of mudharabah and musyarakah. Meanwhile, Bank
Islam Malaysia and Islami Bank Bangladesh channelled
only 1% of their total financing portfolio into the musyarakah
principle. The highest percentage of musyarakah financing was
recorded by Bank Muamalat Indonesia, that is 43.2%, followed
by Shamil Bank of Bahrain and Dubai Islamic Bank at 8.8%
and 7.8%, respectively. However, Bank Muamalat Indonesia
and Dubai Islamic Bank are two banks which actively apply
the mudharabah principle. At the end of 2007, the percentage
of such financing for Bank Muamalat Indonesia was 56.8%
while it was 11.3% for Dubai Islamic Bank. Shamil Bank of
Bahrain had the third highest percentage of financing under
this principle with 9.7% of total financing.
(ii) As for the qard hassan principle or goodwill loan, only Islami
Bank Bangladesh and Islamic International Arab Bank gave
out financing via this principle, that is only 1.3% and 0.2%
of their total financing, respectively. There are two possible
reasons for these low rates. First, there is a possibility that the
managements of Islamic banks view this type of financing
as not bringing any economic returns. Secondly, the banks
may feel that they have already performed many other social
activities and hence regard qard hassan loans as unwarranted.

(iii) All the Islamic banks focus on sale-based principles, in

particular murabahah and bai bithaman ajil. Only Bank Islam
Malaysia provided financing based on the Syariah principle
of bai bithaman ajil, that is, 52.8% of its total financing. Dubai
Islamic Bank and Shamil Bank of Bahrain channelled 91% and
75% respectively of their financing activities into murabahah.
Bank Islam Malaysia had the lowest percentage of murabahah
financing, that is 17.7%.
 Ori KAIIONAl ASPECTS AND PRACTICES Ol ISLAMIC RANKING SYSTEM 305

(iv) The ijarah principle is now gaining the attention of Islamic

banks worldwide. Islamic International Arab Bank, Iordan
allocates the most funds for financing under this principle.
Dubai Islamic Bank channelled 18.5% while Islami Bank
Bangladesh and Bank Islam Malaysia channelled 4.9% and
2.6% respectively of their funds into ijarah financing.

(v) The istisna principle was used in the financing activities of

Dubai Islamic Bank, Kuwait Finance House and Bank Islam
Malaysia. The istisna financing of these banks stood at 13.5%,
8.9% and 4.9% of their total financing, respectively.

TABLE 6-4 Percentage of Financing Based on Syariah Principles

Principle A B C D E F G H
Musyarakah - 8.8 0.1 43.2 - 7.8 0.1
Mudharabah 0.09 9.7 • 56.8 - 113 3.8
Murabahah 17.7 75.0 50.9 - 91.0 45.1 68.1
Bai bithamart ajil 52.8 - - - - - -
Ijarah 2.6 4.9 - - - 18.5 19.3
Qard hassan - 1.3 - - - 0.2
Istisna 4.9 - - - 8.9 13.5
Other principles 21.9 1.6 47.7 - - 3.8 8.5
Total 100 100 100 100 100 100 100

" La*ss than 0,05%. A = Malaysia. Bank Islam Malaysia (Figures as of 30/6/2008)
B - Bahrain, Shamil Bank of Bahrain (Figures as of 31/12/2007)

C ■ Bangladesh, Isiami Bank Bangladesh (Figures as of 31/12/2007)

D - Indonesia. Bank Muamalat Indonesia (Figures as of 31/12/2007)

E - Kuwait Kuwait Finance House (Figures as of 31/12/2007)

F ■ Turkey, Alfarata Turk (Figures as of 31/12/2007)

G - United Arab Emirates, Dubai Islamic Bank (Figures as of 31/12/2007)

H - Jordan. Islamic International Arab Bank (Figures as of 31/12/2007)

30t> CHATTER 6

Islamic banks tend to finance all sectors within the economy as

shown in Table 6-5.

TABLE 6-5 Distribution of Financing Based on Sector (%)

Sector A B C D E F G H
Agriculture 1.1 - 12.6 • 4.1 - 0.6
Manufacturing 11.2 12.2 56.0 0.3 25.6 51.3 24.5 6.8
Construction 5.6 5.65 - 3.5 14.6 16.9 - 9.3
Wholesale and 5.0 - - 0.9 - - 7.9 36.8
retail
Communication 0.8
and
warehousing
Services and 1.0 57.5 - 62.3 54.0 21.4 7.6 10.2
financial
Real estate 31.7 - - - - - 37.1 20.9
Consumerism 18.9 13.9 10.8
Miscellaneous 24.7 24.7 31.4 33.0 5.8 1.6 9.0 4.4
Total 100 100 100 100 100 100 100 100

• Less than 0.1%. Note: List of banks is as in Table 6—1

From Table 6-5. it can be seen that there is no uniformity or

standardization among Islamic banks in the distribution of
financing. Bank Islam Malaysia, for example, concentrates more
on the real estate and miscellaneous sectors, such as construction
and services. Hie real estate sector is also the focus of Dubai
Islamic Bank and Islamic International Arab Bank. It is because
of this high concentration in the housing sector that at the end of
the 2008 financial year, Bank Islam Malaysia recorded bai bithaman
 OPERATIONAL ASPECTS ANl> PRACTICES Ol ISLAMIC HANKING S1STLM 307

ajil as having die highest percentage of financing used, that is

52.8% of its total financing. As for the wholesale and retail sector,
Islamic International Arab Bank has the highest concentration of
financing in this sector. Bank Islam Malaysia, Dubai Islamic Bank
and Islamic International Arab Bank are involved in financing the
consumerism sector, that is 18.9%, 13.9% and 10.8%, respectively.
Only five Islamic banks are involved in the agriculture sector with
Bank Muamalat Indonesia channelling less than 0.1% to this
sector. For Islami Bank Bangladesh. 12.6% of its total financing was
channelled into the agriculture sector in 2007, while it was 4.1%,
1.1% and 0.6% for Albaraka Turk, Bank Islam Malaysia and Islamic
International Arab Bank, respectively. Bank Muamalat Indonesia,
Shamil Bank of Bahrain and Kuwait Finance House allocated
a major portion of their financing, that is 62.3%, 57.5% and 54%
respectively, to the services and financial sector. All eight Islamic
banks listed in the table provide financing to the manufacturing
sector with Islami Bank Bangladesh and Albaraka Turk channelling
the most funds, that is 56% and 51.6% of their total financing,
respectively into this sector.
The concentration of an Islamic bank's financing in a particular
sector is dependent on several factors, which may be categorized
as internal and external factors. External factors consist of aspects
such as economic situation, regulations set by the central bank,
competition and the perception of the local community towards the
bank. If the bank is operating in a country where the industrial sector
is developing rapidly, then there is a high possibility that financing
will be concentrated in the manufacturing sector. Similarly, if the
country is an agricultural country, then the agriculture sector will
be given more attention. Apart from that, the role of the central bank
is also significant in setting the direction and amount of financing.
For instance, the bank must comply with the directives of the central
bank on the issuance of certain financing.
Customer factor is also an important determination of the
amount of financing. If the majority of customers are drawn by
308 CHAPTC* 6

certain factors to patronize an Islamic bank, then they would

obtain financing from an Islamic bank. In contrast, if they prefer
to conduct their banking business with the conventional banks,
Islamic banks may end up financing the less preferred sectors.
Internal factors include the management perception, financing costs
and effectiveness and efficiency in providing products and services.
If the management merely wants to finance sectors that are secure
and provide short-term returns, there is a high probability that
sectors with high risks like agriculture would receive less financing.
Instead, the banks would be more heavily involved in financing the
real estate sector which is regarded as more secure. In addition,
financing costs charged by Islamic banks are higher than those
of conventional banks. Tlais obviously makes conventional banks
more attractive. A number of studies have shown that customers
patronize Islamic banks on the basis of economic factors rather
than religious factors. The final factor is the efficiency of the bank
in giving out loan approvals and the applicability of the financing
provided. Customers prefer banks that grant immediate financing
approval and do not impose too many conditions.

Other Facilities
Apart from deposit and financing facilities, Islamic banks also
provide other facilities to their customers. Such facilities depend
on the capability and capacity of the particular bank. For a
newly-established bank, there is a high possibility that it would be
providing only basic facilities. For example, some Islamic banks
do not issue letters of credit to their customers. In Indonesia, for
instance, only certain banks are allowed to conduct international
trade transactions. Others do not perform foreign exchange
businesses. However, most Islamic banks offer facilities such as
letters of credit for international and domestic trade, letters of
 OITKAIIONA1 ASPrCTS AND l-KAI IKISOI ISLAMIC BANKING SXSTl.M W9

guarantee, foreign exchange, local and overseas money order,

cheque and bank draft issuance, issuance and underwriting of
Islamic securities, syndicated loan, advisory service and consultancy
service, l etters of credit are normally issued to customers who wish
to import goods from overseas, and most letters of credit use the
mudhambah principle. In a mudfurabah letter of credit, the bank acts
as the middleman and imports the goods required by the customer
and subsequently resells the goods to the customer. The following
are the basic steps involved in a letter of credit transaction.
1. The customer asks the bank to open a letter of credit for the
purpose of importing a particular commodity. The customer
will provide the bank with all the information about the
exporter and the commodity he intends to purchase (type,
price, quantity, size, etc.).
2. If approval is granted, and after receiving a guarantee either in
the form of deposit or other forms, the bank will issue a letter
of credit (the bank that issues the letter of credit is called the
issuing bank), the contents of which are in accordance with the
customer's request. This letter will be sent to the bank that is
acting as his representative (known as the representative bank)
where the exporter resides.
3. The customer will sign an "agreement to purchase" the imported
commodity. The bank and customer will negotiate on the cost of
the commodity' to be sold and the terms of delivery'.
4. The exporter will execute the delivery of the commodity
as stipulated in the letter of credit, after which all delivery
documents will be submitted to the representative bank. The
representative bank in turn delivers the documents to the
issuing bank.
5. When all the documents have reached the issuing bank and the
issuing bank endorses its ownership rights on the commodity.
310 CHATTER 6

the customer will then sign a letter of sale and purchase

agreement of the commodity.

Bank Islam Malaysia issues its letters of credit by using three

separate methods based on wakalah, musyarakah and sale with profit
mark-up (miirabahah). The choice of method depends on the needs
of the customer. The following are the transactions involved in the
use of such services,

Wakalah Letter of Credit

When the wakalah principle is applied, the bank acts as the agent
or representative in the transaction involving the purchase of the
commodity on behalf of its client, and the bank receives a payment
for the service provided. The steps involved are as follows:

1. The customer informs the bank of his letter of credit requirement

and negotiates the terms.

2. The customer will place a deposit towards the purchase of the

goods in the deposit account based on the wadiah principle.

3. The bank establishes the letter of credit.

4. Upon receipt of the documents or information via telex

regarding negotiations of the letter of credit, the bank will remit
the payment to the seller utilizing the customer’s deposit.

5. The bank charges the customer a commission fee based on

the principle of fees, commission and fixed payment, and
management expenditure associated with the facility and
service of letters of credit.

6. Tlie bank submits the related documents to the customer.

OrERATIONAl. ASPECTS AND PRACTICES Or ISLAMIC BANKING SYSTEM 311

Musyarakah Letter of Credit

Under this principle, the bank acts as the partner in the transaction
involving purchase of the goods concerned. In addition to
managing all the relevant documents for the import of the goods,
the bank also issues part of the capital to finance the purchase of
the goods. The steps involved are as follows:

1. The customer informs the bank on the type and features of the
goods he intends to import or purchase, as well as the terms for
issuance of the letter of credit.

2. The customer deposits his share of the financing with the bank
under the wadiah principle.

3. The customer and the bank both agree to contribute their

capital and expertise in the import or purchase of the goods
based on the musyarakah principle and seal the agreement which
contains terms based on miisyarakah, such as contribution of
their respective portions of capital, profit apportionment ratio
and other such matters.

4. The bank issues the letter of credit.

5. Upon receipt of the documents or information via telex

regarding negotiations of the letter of credit, the bank will remit
the payment to the seller utilizing the customer’s deposit and
the bank's share of financing.

6. The bank imposes a commission fee on the customer based on

the principle of service reward and management expenditure
associated with the facility and service of letters of credit.

7. The bank releases the documents to the customer, and the

customer takes possession of the goods in the manner set forth
in the agreement.
312 CHATTtK6

8. The bank and customer share in the profit from the venture as
provided for in their agreement.

Murabahah Letter of Credit

Under this principle, the Islamic bank acts as the businessman. The
bank will first purchase the goods from a producer, and then resell
it to the client at a higher price. The steps involved are as follows:

1. The customer informs the bank on the type and features of the
goods he intends to import or purchase, as well as the terms for
issuance of the letter of credit.

2. The customer negotiates with the bank for it to purchase

the goods in advance and to subsequently sell the goods to
the customer at a sale price comprising its cost and a profit
margin.

3. The bank issues the letter of credit.

4. Upon receipt of the documents or information via telex

regarding negotiations of the letter of credit, the bank will remit
payment to the seller utilizing its own fund.

5. The bank sells the goods to the customer based on the murnl’iihilli
principle.

6. The bank charges the customer a commission fee based on

the principle of fees, commission and fixed payment, and
management expenditure associated with the facility and
service of letters of credit.
 OrCHATlONAI ASPECTS ANO PRACTICES Of ISLAMIC HANKISG SYSTEM 313

Kafalah Letter of Guarantee

The issuance of letters of guarantee is based on the principle of fees,

commission and fixed payment. Bank Islam Malaysia issues this
letter of guarantee based on the principle of kafalah or secured debt.
The steps involved in using a letter of guarantee are as follows:

1. The customer submits an application to the bank to issue a letter

of guarantee to a third part)' for the purpose of settlement of a
loan or successful performance of a task.

2. The bank issues a letter of guarantee to the third party and agrees
to assume the liability of the customer in the case of default or
breaching of contract as agreed between the customer and the
third party.

3. The customer may be required to place a certain amount of

deposit, which the bank accepts under the principle of wadiah.

4. The bank charges the customer a fee for the service provided
based on the principle of ujr.

Sendees such as money order, foreign exchange, sale and purchase

of travellers cheque, etc., are based on fees, commission and fixed
payment. For foreign exchange transactions, spot rate and not
forward rate is used. For example, Islami Bank Bangladesh offers no
forward transactions for foreign exchange facilities. However, the
additional facilities provided by Islamic banks vary from one bank
to another due to factors such as expertise, location and emphasis
on facilities extended by the bank. For instance, the involvement
of a bank in international trade can be seen from the amount of
contingent liabilities of the bank. The contingent liabilities of
selected banks are shown in Table 6-6.
314 CHATTER 6

TABLE 6-6 Percentage Breakdown of Contingent Liabilities

Type of Liability A B c D E F G H
Letters of credit 5.6 24.7 79.7 19.1 31.9 18.4 34.2 19.1
Letters of 6.8 - 6.1 80.9 50.3 75.1 57.7 11.0
guarantee
Foreign exchange 31.0 - - - - - - -
contract
Bills for 5.5 - 12.5 - - - - ■T
collection
Other liabilities 51.1 75.3 1.8 - 17.8 17.8 8.1 69.9
Total 100 100 100 100 100 100 100 100
Total assets (%) 39.6 6.9 30.9 8.8 14.3 27.3 21.5 11.5

Note: List of banks is as in Tabic 6-4.

From Table 6-6, we can conclude that:

(i) The types of international services offered differ among

Islamic banks. While letter of credit is available at all banks,
facilities such as letter of guarantee, foreign exchange and bills
for collection are available only at selected banks.

(ii) Bank Islam Malaysia is the only Islamic bank that provides
all facilities in international trade. Foreign exchange futures
contract is not provided by banks in West Asia. Likewise for
bills for collection services.

(iii) There are also some differences in terms of emphasis on

facilities extended by Islamic banks to their customers.
Islamic bank in Bangladesh seems to concentrate on letters of
credit facilities, whereas Islamic banks in Indonesia. Turkey,
 OPERATIONAl ASPECTS AND PRACTICES Of ISLAMIC BANKING SYSTEM 315

Dubai and Kuwait tend to concentrate on providing letters of

guarantee. Meanwhile, Islamic banks in Bahrain and Jordan
are more inclined towards other liability facilities. These other
facilities may be forms of financing that have already been
approved but not yet used by customers.

(iv) The extent of additional facilities provided also varies

between Islamic banks. Bank Islam Malaysia has the highest
exposure in terms of contingent liabilities; its contingent
liabilities are 39.6% of total assets. This is followed by
Islami Bank Bangladesh with 30.9% and Albaraka Turk
with 27.3%. The banks with the lowest exposure are
Islamic International Arab Bank, 11.5%, Shamil Bank of
Bahrain, 6.9% and Bank Muamalat Indonesia, 8.8%.

SOURCES OF FUNDS

Generally, there are three main sources of funds for Islamic

banks, namely deposit, other liabilities and shareholders' funds.
The amount of capital issued depends on the financial strength
of those who wish to establish the Islamic bank concerned. The
Dallah Albaraka Group has invested a huge part of its funds for
the establishment of Islamic banks. Bank Negara Malaysia has set a
minimum share capital requirement of RM300 million for foreigners
wishing to set up Islamic banks in Malaysia. This deposit in turn
is divided into several types, as already explained in the previous
section (Deposit facilities). Other contributions arc funds acquired
from other liabilities, which are usually in the form of short-term
liability. Meanwhile, shareholders' funds consist of paid-up capital,
various reserves and retained eamings. The sources of funds of
Islamic banks in particular countries are shown in Table 6-7.
316 CHATTER 6

TABLE 6-7 Sources of Funds of Islamic Banks (%)

Source of funds A B c D E F G H
Deposit 88.4 72.3 86.9 87.0 74.4 81.2 77.6 84.8
Shareholders' 5.6 20.5 6.2 8.0 16.0 14.5 12.7 12.5
funds
Others 6.0 72 6.9 5.0 9.6 4.3 9.7 3.1
Total 100 100 100 100 100 100 100 100

Note: List of banks is as in Table 6-4.

Based on the figures shown in Table 6-7, Bank Muamalat Indonesia

is the bank with the highest amount of funds deposited by
customers, about 87% of its overall assets at the end of the 2007
financial year. The percentage figures for other Islamic banks are
within the range of 70% to 90%. Shamil Bank of Bahrain has the
lowest percentage figure, only 72.3% in the year 2007, followed
by Kuwait Finance House with 74.4%. The low percentage figure
registered by Shamil Bank is due to the fact that investment accounts
are not considered as liabilities, and hence are consequently
removed from the financial statement, while deposit account is
shown to be consisting of current account and savings account
only. Shamil Bank also has the highest percentage of shareholders'
fund, that is 20.5%. Banks which recorded low shareholders’ funds
are Bank Islam Malaysia with 5.6%, Islami Bank Bangladesh,
6.2% and Bank Muamalat Indonesia, 8%. In line with Basel 11 (an
effort by the Basel Committee on Banking Supervision to update
the original international bank capital accord), banks worldwide
must hold capital reserves appropriate to the risk the bank exposes
itself to through its lending and investment practices. The
composition of deposits of Islamic banks is shown in Table 6-8.
 OPERATIONAL ASPECTS ANO PRACTIC IS Ol ISLAMIC BANKING SYSTEM 317

TABLE 6-8 Deposit Composition of Islamic Banks (%)

Source of funds A B C D E* F G H
Current accounts 28.2 26.9 "■5, 10.6 14.4 21.2 21.3
Savings accounts 11.7 - 375 38.0 - 13.4 4.1
Investment 30.5 50.0 18.7 51.4 85.6 64.0 74.6
accounts
Other accounts 29.6 23.9 323 - 1.4 -
Total 100 100 100 100 100 100 100

Note: List of banks is as in Table 6-4.

"No breakdown of deposit account is shown by Kuwait Finance House.

Based on Table 6-8, the following are the deposit composition of

Islamic banks.

(i)Except for Shamil Bank of Bahrain and Albaraka Turk, Turkey,

Islamic banks in other countries offer three types of deposit
facilities to their customers, namely current account, savings
account and investment account. Although current account
does not give out any reward, most of the deposit made by
customers is of this form. Bank Islam Malaysia has the highest
percentage of current accounts, that is, 28.2%, followed by
Shamil Bank of Bahrain with 26.9%. Furthermore, total fund
deposited in the current account facility is more than 10'5,
on average; thus suggesting that customers do not require
rewards or hibah. However, the investment account facility
has the highest percentage of deposited funds. Albaraka Turk,
Turkey has the highest percentage of investment accounts,
that is, 85.6%, followed by Islamic International Arab Bank,
Jordan with 74.6%. All investment deposits available at Islamic
banks are governed by the profit-loss sharing or mudharabah
principle.
318 CHAFTF.K 6

(ii) Savings account is not very popular among depositors

in Jordan and Malaysia, comprising only 4.1% and 11.7%
of total deposits of Islamic International Arab Bank and
Bank Islam Malaysia, respectively. This is in contrast with other
banks such as Islami Bank Bangladesh and Bank Muamalat
Indonesia which have recorded relatively higher percentage
of savings accounts; 38% and 37.5%, respectively. Two factors
contributing to this difference have been identified. First,
other banks apply the mudharabah principle while Malaysia
uses the wadiah principle. Secondly, other banks offer various
forms of savings accounts, and thus are better able to attract
depositors.

(iii) Bangladesh and Malaysia are two countries where "other

deposits" constitute a relatively high percentage of the banks'
deposit composition. During the 2007 financial year, other
accounts comprised 32.3% of the total deposits in Bangladesh,
while in Malaysia it was 29.6%. In Bangladesh, the bulk of this
deposit is mainly from the marginal deposits required by tire
banks prior to the issuance of letters of credit and letters of
guarantee. In the case of Malaysia, customers who deposit
their money into this facility are mainly the government and
government agencies.

USES OF FUNDS

How Islamic banks use their funds is represented by the types

of assets held which mainly belong to five main categories,
namely cash, financing, investment, fixed assets and others. Cash
includes cash in hand, balance with the central bank or reserves
and balances with other financial institutions. Banks normally do
not hold high percentages of cash. The amount of reserves each
 OPERATIONAL ASPECTS AND PRACTICES OP ISLAMIC BANKINC SYSTEM 319

bank keeps with the central bank depends on the ratio set by the
central bank of the particular country. It also depends to a large
extent on how the central bank implements its financial policies
as well as on the country's inflation rate. Financing comprises all
loans extended under the principles of mudharabah, musyarakah,
murabahah, bai muazzal, ijarah and qard hassan. Investment includes
investment in government securities, treasury bills and investment
in subsidiaries and associated companies. Fixed assets include all
land and buikiings, vehicles, factories, furniture and fixtures. All
other assets which cannot be categorized under the four mentioned
categories are classified as other assets. The uses of funds by Islamic
banks are shown in Table 6-9.

TABLE 6-9 Uses of Funds by Islomic Banks (%)

Uses of funds A B C D E F G H
Cash 42.2 28.2 8.9 1.6 6.3 4.0 5.9 5.9
Financing 38.5 39.4 75.7 38.7 57.5 73.0 58.4 51.1
Investment 15.6 26.9 10.6 0.4 6.7 0.1 11.3 4.3
Fixed assets 0.5 0.6 4.5 0.7 4.6 1.1 0.8 1.5
Other assets 3.2 4.9 0.3 58.6 24.6 21.8 23.6 37.2
Total 100 100 100 100 100 100 100 100

Note: List of banks is as in Table 6-4.

Table 6-9 shows that there exist similarities and differences in terms
of the uses of funds by Islamic banks. Variations are reflected by
the differences in terms of preferences as well as in the percentage
of funds allocated for various categories of assets. The following
are some prominent features in terms of the uses of funds among
Islamic banks,
320 ClIATltK 6

(i) With the exception of Bank Islam Malaysia, Bank Muamalat

Indonesia and Shamil Bank of Bahrain, Islamic banks in
other countries are concentrating on financing activities.
For example, Islami Bank Bangladesh and Albaraka Turk have
channelled more lhan 70% of their funds into these activities.
Other banks which concentrate on financing activities are
Dubai Islamic Bank, 58.4%, Kuwait Finance House, 57.5% and
Islamic International Arab Bank, 51.1%. The low percentage of
funds allocated to financing activities by some Islamic banks
is due to factors such as limited business opportunities, or the
policy of the banks which puts a limit on funds for financing
activities. In theory, the more funds allocated for financing, the
more profits they acquire. However, high financing could also
expose the banks to bad debt problems.

(ii) There are four banks which give priority to investment,

namely Shamil Bank of Bahrain, 26.9%; Bank Islam Malaysia,
15.6%; Dubai Islamic Bank, 11.3% and Islami Bank Bangladesh,
10.6%, The higher percentage of investment activities is due
to the fact that governments of the countries in which these
banks operate issue securities based on Islamic principles, thus
creating an investment avenue for Islamic banks. For instance.
Bank Islam Malaysia can invest in Synniih-compliant government
securities. Similarly for Islamic banks in Dubai and Bahrain.
In other countries, Islamic securities are still not widespread,
and hence opportunities to invest through the purchase of
Syaria/i-compliant securities are somewhat limited.

(iii) Most of the Islamic banks have a low percentage ofcash in their
funds, with the exception of two banks. Bank Islam Malaysia
and Shamil Bank of Bahrain maintain high liquidity of about
42.2% and 28.2% of the total assets, respectively. Cash reserves
held by other Islamic banks are in the range of 5% to 10%.
Bank Muamalat Indonesia has the lowest cash holding, that is
1.6% of total assets, followed by Albaraka Turk, Turkey with
 OPERATIONAL ASPECTS ANO PRACTICES Of ISLAMIC HANKINC SYSTEM 321

4%. If there are no restrictions on the inflow and outflow of

funds in a country, Islamic banks with surplus funds may be
able to undertake investments in international markets centred
in Bahrain or at the Labuan International Financial Exchange
which has already listed securities and bonds issued based on
Syariah.

(iv) In general, the proportion of fixed assets held by Islamic

banks is not more than 2% of the total assets. Kuwait Finance
House has the highest percentage of fixed assets, 4.6% of
total assets, followed by Islami Bank Bangladesh with 4.5%.
Heavy concentration in fixed assets represents a loss to the
bank. This is because the larger the value of fixed assets, the
bigger the annual depreciation charge that must be deducted
from the bank’s net income.

(v) There is no significant differences in the percentage of "other

assets" held by Islamic banks, except for Bank Muamalat
Indonesia where the percentage of other assets to total
assets is 58.6%. As for other Islamic banks, this percentage is
not that high and most of the assets held are in the form of
transactions among subsidiary companies. However, Islami
Bank Bangladesh recorded the lowest percentage of other
assets, that is 0.3%. This is followed by Bank Islam Malaysia at
3.2% and Shamil Bank of Bahrain at 4.9%.

The type of investment undertaken can influence returns or income

received by an Islamic bank. The short-term and long-term trend
of income also depends largely on the investment made. The types
of investment include investment in subsidiaries and associated
companies, Islamic securities, real estate and company shares. The
types of investment and the amount of funds allocated for each
type of investment vary among banks. Table (>-10 shows the types
of investment undertaken by Islamic banks.
322 CHATTER 6

TABLE 6-10 Investment Undertaken by Islamic Banks (%)

Type A B C D E F G H
Securities 99.6 40.0 100 27.0 60.4 96.8 39.6 100
Subsidiaries 0.4 29.7 73.0 23.0 15.9
& associated
companies
Real estate - - - - 16.6 3.2 44.5 -
Others - 30.0 - - -
Total 100 100 100 100 100 100 100 100
Investment out 15.6 22.0 10.6 0.5 16.9 16.0 11.3 4.3
of total assets (%)

Note: List of banks is as in Table 6-4.

Table 6-10 shows that there are several similarities and differences
in terms of the amount and distribution of investment made by
Islamic banks in selected countries. Some of the main features are
as follows:

(i)Only four banks concentrate on investment activities.

They are Shamil Bank of Bahrain, Kuwait Finance House,
Albaraka Turk and Bank Islam Malaysia, which allocated
22%, 16.9%, 16% and 15.6% of their funds respectively for
investment activities. However, the type of investment differs
among them. For example, both Islami Bank Bangladesh and
Islamic International Arab Bank invested 100% in securities.
On the other hand, 99.6% and 96.8% of Bank Islam Malaysia's
and Albaraka Turk's investment activities were in securities,
while for the other banks such investment was in the range
of 40% to 60%. Investment in securities include investment in
central government and state government securities, treasury
bills, stocks and shares, bonds and unit trusts.
OriKATlONAl ASPECTS AND FRAC IIC ES OF ISLAMIC BANKING SYSTEM 323

(ii) The second preferred area of investment is investment in

subsidiaries and associated companies. Bank Muamalat
Indonesia had 73% of this form of investment in 2007.

(iii) Real estate is the least preferred form of investment for most
Islamic banks, except for Dubai Islamic Bank. The percentage
of such investment made by Kuwait Finance House and
Albaraka Turk. Turkey was very low.

SOCIAL AND WELFARE ACTIVITIES

Most Islamic banks have a high sense of corporate social

responsibility. The issue lies in how much and how far this
responsibility' is actually implemented, and whether this
information should be made public by the Islamic banks. The
Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI), an organization responsible for preparing
and issuing accounting standards of Islamic banks, has released
standards relating to the account presentation and account
statement of Islamic banks. AAOIFI does not provide any
standards on matters relating to social responsibility. Nonetheless,
the organization is currently developing a governance standard on
corporate social responsibility. It does, however, provide standards
that deal with the determination of zakal base, measurement of
items to be included in the zakal base and disclosure of zakat in the
financial statement of Islamic banks. In this case, zakal is regarded
as a social rather than religious responsibility'. AAOIFI has also
recommended that the statement related to ijard hassan loans be
provided if a bank issues loans of this kind. Based on the latest
financial statements, only Islamic International Arab Bank, Jordan
prepared financial statement on this matter. Shamil of Bank Bahrain,
Islami Bank Bangladesh, Kuwait Finance House, Albaraka lurk and
Dubai Islamic Bank have not prepared financial statement on qartl
324 CHATTER 6

hassan loans as suggested by AAO1FI. Bank Muamalat Indonesia

did, however, provide a statement on qard hassan loans which was
presented in the form of notes to the account.
Factors such as the absence of zakat collecting activities, the
low amount of qard hassan loans given out and the absence of laws
or written regulations requiring Islamic banks to carry out social
activities may have induced Islamic banks not to comply with
standards related to zakat and qard hassan loans. For example, the
establishment laws of Jordan Islamic Bank clearly state the bank’s
social role, which is to enhance ties and cooperation among society
and among community members through:
(i) Granting benevolent loans to the needy in order to enable
the recipients to be independent or meet certain financial
obligations.
(ii) Creating and administering funds or specific savings for a
variety of beneficial social purposes.
(iii) Other miscellaneous social activities which are subjected to
the general objectives mentioned above.

In line with the regulations set, Jordan Islamic Bank has carried out
various social activities and has listed them in its annual financial
statements. Contributions and donations that the bank granted to
mosques, the Holy Quran memorization prizes, zakat committees
and other charitable associations amounted to JOD201,500 in
2007. (Jordan’s official currency is the Dinar or JOD.) A total of
JOD8.7 million of qard hassan loans were granted during 2007 from
which 19.112 people benefited. In terms of financing to craftsmen
and small-scale industries, the bank had financed 71 projects bv the
end of 2007 amounting to J(JD1.6 million. The bank also patronized
file mutual insurance fund where the compensation paid from
this fund amounted to JOD385.000 in 2007. The total number of
recipients who had benefited from this fund at the end of 2007
was 81,371 and the outstanding balance was JOD17.86 million.
Jordan Islamic Bank also supports other miscellaneous social
OPERATIONAL ASPECTS AND PRACTICES OT ISLAMIC BANKING SYSTEM 325

activities including education aid. humanitarian relief within and

outside the country, and assistance to other welfare organizations.
Likewise, Islami Bank Bangladesh has shown tremendous
commitment towards its social role since its inception. This
is in accordance with the objectives of its establishment. To
consolidate its social activities, Islami Bank Bangladesh has set up
an organization called Islami Bank Foundation. This Foundation
has apportioned financial aid to those in need through various
programmes such as income generating programmes, healthcare
and medicare programmes, humanitarian help programmes,
educational programmes, relief and rehabilitation programmes
and dakwali (religious outreach) programmes. This Foundation
has established six modem hospitals, two service centres and
five vocational training institutes. In addition, the bank has
also implemented programmes to develop human resources by
providing them with skills in specific areas so as to improve their
economic condition and quality of life. A special institute that
provides religious and moral education has also been established.
The social programmes carried out by this bank have also been
taken up by other Islamic banks in Bangladesh. For example, the
major activities of Social Investment Bank Limited which was
established in 1995 are directed towards the welfare of the society
in Bangladesh. This bank works towards developing various sectors
in Bangladesh, including modernizing the management of social
organizations such as mosques, colleges, wakaf institutes and other
welfare organizations, as well as developing the properties that had
been created through the processes of wakaf, charity and donation
to bring about higher and more effective returns. In relation to this,
Social Investment Bank has introduced a cash wakafcertificate where
income from these funds is used to implement activities allowed by
Syariah (www.siblbd.com). Apart from that, the bank also makes
available a social savings fund which is to provide assistance to
the poor and needy. Sources of the funds include the bank's annual
profit as well as public contributions.
 The social activities of Bank Muamalat Indonesia are carried
out through Baitulmaal Muamalat which has developed a variety
of programmes such as B-Community, B-Care, B-Smart and B-BMT.
Through the B-Community programme, efforts are channelled
towards developing self-sufficiency in communities and promoting
community welfare. The B-Care programme involves distribution
of aid to victims of natural disasters such as floods and fires as
well as to those suffering human tragedy including wars, famines
and diseases. Baitulmaal Muamalat distributed a total of Rp9.6
billion in relief aids to natural disaster victims in Indonesia in 2007
(Indonesia's official currency is the Rupiah or Rp). Educational aid
in the form of scholarship grants (a full-year tuition fee) to students
of private and state universities is distributed through the B-Smart
programme. The recipients of this aid are given the opportunity
to participate in the various social activities conducted by Bank
Muamalat Indonesia. As at the end of 2007, Baitulmaal Muamalat
has granted a total of 1,600 scholarships to the tsunami orphans
of Aceh. The B-BMT programme is a micro-financing programme
designed to enhance the development of micro businesses. Aid is
normally given in the form of working capital and work facilities.
Bank Muamalat Indonesia also provides service for the mobilization
and distribution of zakat. Zakat amounting to Rpl2 billion has been
mobilized by the bank (Bank Muamalat Indonesia, 2007).
Dubai Islamic Bank also implements a range of social activities
which benefit various sectors of Islamic societies and groups in
the United Arab Emirates. The bank provides a zakat savings fund
where funds are obtained from shareholders’ profit This zakat
fund, known as samtoui/ al-zakat. is placed in a dedicated account
and transacted separately. The bank also receives zakat money from
other parties or customers who appoint the bank to pay zakat from
their money and to use the money for charity and other welfare
purposes in accordance with Syariah. The funds from the zakat
savings are mostly given to orphans, welfare organizations, students
and those in need, either within or outside of the Emirates. Another
 Ol'FRATIONAL ASPECTS AND PRACTICES OF ISLAMIC HANKING SVSII M 327

social activity conducted by Dubai Islamic Bank is the provision of

interest-free loans, or yard liassan for marriage, medical treatment
and debt repayment. In 2007, a total of 1,928 qard hassan loans
totalling Dhl8.48 million were issued. (The currency in Dubai is
called dirham or Dh). Apart from this, the bank on its own initiative
had conducted research and inquiry on the methods of slaughter
of animals whose meat is imported into Dubai. On discovering
that most of the animals were slaughtered through electrocution,
the bank, with the cooperation of Dubai Co-operative Society held
negotiations with major companies in Europe for the slaughter of

from both the bank and the cooperative society were sent to conduct
as well as to monitor the slaughtering at these slaughter houses.

ACCOUNTING POLICIES

Islamic banks must comply with Islamic business principles in

all their transactions. Instead of interests, Islamic banks use four
main mechanisms in mobilizing their funds. These mechanisms are
profit-loss sharing, sale and purchase, fixed charges or commission
and free service. As such, many Muslim scholars are of the view
that Islamic banks should have methods of measuring, recording
and reporting of transactions that are different from those of
conventional banks. In general, the preparation and presentation of
financial statements of conventional banks are based on accounting
systems of the West which place importance on the economic
interest of a particular transaction as well as the information
required by users of the financial statement. 1 lowever, the principal
objective of the financial statement of the Islamic bank is not only
to report the financial position of the bank, but also to provide
information which customers and users of the statement need in
order to assess the bank's compliance with the precepts of Syariah.
328 CHAPTI:n 6

The task of ensuring that the Islamic bank does not violate Syariah
rules is done by the Syariah Supervisory Board. The Board will
issue a report as to whether the bank has complied with Syariah
principles or otherwise and this account is published in the annual
report of the bank.
A pure Islamic bank has yet to exist as the majority of Islamic
banks are still using Western accounting systems to record business
transactions and generate financial information. There are,
however, some banks which have created their own accounting
standards. The initial step to create accounting standards for
Islamic banks was taken by Islamic Development Bank during
its annual meeting in 1987. It received strong support from other
Islamic banks. The outcome of the meeting was the establishment
of a Steering Committee with the aim of recommending the
appropriate and suitable accounting standards for Islamic banks.
In 1988, the Steering Committee presented its report but not all
members accepted the recommendations made by this committee.
As a result, a new committee was set up to review and improve
on the recommendations made by the earlier Steering Committee.
Although the accounting standards put forward by this new
committee were endorsed and accepted, the committee did not
propose the method of implementation. It was because of the
absence of a concrete implementation rule or guide that Islamic
banks subsequently created their own accounting policy. They took
into account views of the Syariah Committee as well as external
auditors in developing their accounting policies. The accounting
policy is also dependent on the banking regulations and laws of the
country where the Islamic bank operates.
When choosing which policy to adopt, the majority of Islamic
banks would use the policies already adopted by other pioneer
Islamic banks as a benchmark. However, banks which belong to the
same parent company or are subsidiaries, would normally adopt
OPERATIONAL ASPECTS AND PRACTICES OT ISLAMIC BANKING SYSTEM 329

the accounting policies of the parent company. There are reporting

variations among Islamic banks in preparing their financial
statements. These differences occur not only among Islamic banks
in different countries, but also among Islamic banks in the same
country. For example. El Charb Islamic Bank of Sudan does not
report its accounting policy while Tadamon Islamic Bank of Sudan
does.
It was as a result of the recommendations made regarding the
need to have a common standard of accounting for Islamic banks
during a meeting of Islamic Development Bank in Jeddah, that
the Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI) was formed in 1991. Having uniform
accounting standards for Islamic banks is crucial because the
objective of reporting in Islamic banking differs substantially from
that of conventional banking. While the accounting objective of
the conventional bank is to aid the decision making of users of the
financial statement, the accounting objective of the Islamic bank is
to enable users to assess the bank's compliance with Syariah laws.
Since its inception, AAOIFI has successfully produced several
standards related to accounting and other financial transactions
of Islamic banks. These consist of 23 accounting standards,
5 auditing standards, 6 governance standards, two codes of ethics
for accountants and auditors in Islamic financial institutions and
30 Syariah standards. The standards of financial accounting issued
by AAOIFI concentrate mostly on transactions in Islamic financial
institutions based on Syariah principles. The standards developed
by AAOIFI are comprehensive and include matters related to
the basics of financial statement preparation, income recognition
and expenses, methods of recording investments undertaken,
allocation of doubtful debts, record of fixed assets and depreciation,
distribution of profit between the banks and the depositors, payment
of zakat and responsibility on all expenses issued.
330 CHATTER 6

The Basis of Financial Statement Preparation

Although AAOIFI has prepared accounting standards for Islamic
banks, they are not legally bound to comply with these standards.
However, some countries require Islamic banks to comply with
standards and legislation imposed by the regulatory' authority
of those countries. For example, Bank Islam Malaysia and
Bank Muamalat Malaysia prepare their financial statements in
accordance with the provisions issued by the Malaysian Accounting
Standards Board, provisions of the Companies Act 1965 and
approved accounting standards in Malaysia, Bank Negara Malaysia
Guidelines and Syariah requirements. Both banks do not make
any reference to the accounting standards issued by AAOIFI.
Island Bank Bangladesh asserts that the basis for preparing the
financial statements is subject to the formats and provisions as
prescribed under the Banking Company Act 1991, the International
Financial Reporting Standards adopted as Bangladesh Accounting
Standards, the Companies Act 1994, the Securities and Exchange Rules
1987, Dhaka and Chittagong Stock Exchange's Listing Regulations
and other laws and rules applicable in Bangladesh, and AAOIFI
standards. Bank Muamalat Indonesia reports that its financial
statement preparation is in conformity with the Statement of Financial
Accounting Standards No. 59 "Accounting for Sliaria Banks", the
Accounting Guidelinesfor Indonesian Sharia Banks and other principles
issued by the Indonesian Institute of Accountants as well as other
standards imposed by Bank Indonesia and the Capital Market
Supervisory Agency. As for Kuwait Finance House, the preparation
of its financial statement is in accordance with the International
Financial Reporting Standards. Meanwhile, Islamic banks in Turkey
keep their accounting records and prepare their unconsolidated
financial statements in accordance with the accounting and
valuation standards described in the Turkish Accounting Standards
and Turkish Financial Reporting Standards. Similarly, in preparation
of its financial statements. Dubai Islamic Bank follows (he standards
 oreKATioNAL aspects ano pkactices or Islamic banking system 331

issued by the International Accounting Standards Board and other

policies issued by the United Arab Emirates.
Islamic banks which comply with AAOIFI standards are mostly
those originating from the Middle East such as Shamil Bank of
Bahrain. Albaraka Islamic Bank of Bahrain, Islamic International
Arab Bank and Qatar Islamic Bank. These banks have clearly stated
that their financial statement preparations are in accordance with
the AAOIFI standards. They also follow the additional standards
imposed in their respective countries. These observations highlight
that the acceptance of accounting standards established by AAOIFI
is relatively low which may be due to the voluntary nature of
AAOIFI itself. There is a high possibility for the standardization of
annual reporting among Islamic banks if the functions of AAOIFI
are assumed by the Islamic Financial Services Board.

Revenue Recognition
Revenue recognition is the record of revenue when an exchange
transaction has taken place or when the earning process has been
completed. The principle of revenue recognition states that revenue
is recognized either when it is earned or when it is realized.
The timing of revenue recognition warrants careful observation
because it is critical to the measurement of net income. Generally,
revenues are recognized at the time of sale or provisioning of service.
Not all Islamic banks describe their revenue recognition policy
in their annual reports. Those who do are Bank Islam Malaysia.
Shamil Bank of Bahrain, Albaraka Islamic Bank, Kuwait Finance
House and Dubai Islamic Bank. Nonetheless, the methods of
recognizing revenue vary among them. Islami Bank Bangladesh, on
the other hand, does not provide any explanation as to the method
used in revenue recognition. AAOIFI has issued a guide on revenue
recognition and has suggested that revenues are realized when all
the following conditions are satisfied (AAOIFI, 2000, p. 61):
332 CHAPTER 6

• The bank has the right to receive revenue which means that the
earning process should be complete. The point at which the
earning process is complete differs between types or sources
of revenues. For example, the earning process for revenue
from services is complete when the bank delivers the service.
Similarly, the earning process for revenue from the sale of goods
is complete upon their delivery, while the process for revenue
earned from allowing others to use the bank's assets (leasing) is
complete through the passing of time.

• There exists an obligation on the part of another party to remit

a fixed or a determinable amount to the bank.

• The amount of revenue should be known and collectible with

reasonable degree of certainty, if not already collected.

There are similarities in the revenue recognition policies of

Bank Islam Malaysia and Bank Muamalat Malaysia. For both
banks, revenues are recognized on an accrual basis. Revenues from
financing of customers are recognized based on the constant rate of
return method while income from dealings and in vestment securities
is recognized based on an effective yield basis. When an account
is classified as non-performing, revenue will not be recognized
until it is realized on a cash basis. The account is classified as
non-performing if repayments are in arrears for more than a period
of six months. This policy is in accordance with the guidelines
provided by Bank Negara Malaysia. Islamic banks in Malaysia
follow file MASBi-1 standards which are the accounting standards
for Islamic banks set by the Malaysian Accounting Standards Board.
Shamil Bank of Bahrain in its 2007 annual report described in
detail its revenue recognition policy as follows (Shamil Bank, 2007,
p. 50):

• Profit participation and management fees

Income from profit participation and management fees charged

to funds managed by the bank is recognized on the basis of
OPEKATIONAl ASPECTS AND PRACTICES OT ISLAMIC BANKING SYSTEM 333

the bank’s entitlement to receive such revenue from restricted

and unrestricted investment accounts as stipulated in the
mudharabah agreement, except when the bank temporarily
waives its entitlement.

• Profits from miirabahah and istisna transactions

The profits acquired through murabahah and istisna transactions

are recognized by proportionately allocating the attributable
profits over the period of transaction where each financial
period carries its portion of profits irrespective of whether or
not cash is received. Profit is not accrued on murabahah and
istisna transactions if the repayment instalments are overdue
for more than 90 days, unless the director considers the accrual
as justified.

• Income from assets for rent

Income from rented assets is proportionately allocated over

the rental period so as to provide a constant rate of return
throughout the rental or lease term.

• Income from mudharabah contracts

Income from mudharabah contracts is recognized when the

mudarib declares profits.

• Profits from tnusyarakah contracts

In the event that a musyarakah contract exceeds more than one

financial period, the bank's share of the profit is recognized when
the partial or final settlement takes place. Losses are recognized
to the extent that such losses are deducted from the bank’s share
of musyarakah capital. However, with regard to diminishing
musyarakah transactions, profits and losses are recognized after
considering the decline in the bank's share of the musyarakah
capital and Consequently, its proportionate share of the profit or
losses.
334 CHAriiKb

• Dividend income

Dividend income will be recognized when the right to receive

payment is established.

• Fees and commissions

Fees and commissions are recognized as income when

payment is received. Commissions on letters of credit and
letters of guarantee are recognized as income over the period
of transaction. Fees for structuring and arranging financing
transactions for and on behalf of other parties are recognized
after the bank has fulfilled its obligations in relation to the
related transactions.

Among Islamic banks that describe their revenue recognition

method in detail are Dubai Islamic Bank and Albaraka Islamic
Bank, Bahrain. The following are examples of the methods
practised by Dubai Islamic Bank (Dubai Islamic Bank. 2007).

• Murabahah

If the income is quantifiable and contractually determined at

the beginning of a contract, then this income is recognized on a
time-apportioned basis over the period of the contract based on
the principal amount outstanding.

• Istisna

Isfisnit's revenue and the associated profit margin (the

difference between cash price of al-masnoo to the customer
and the total istisna cost to the bank) are computed based on a
time-apportioned basis.

• Ijarah

Ijarah income is recognized based on a time-apportioned basis

over the lease term.
OPERATIONAL ASPECTS AMI PRACTICES OF ISLAMIC BANKING SYSTEM 335

• Musyarakah

Income is computed based on the reducing balance on a

time-apportioned basis that reflects the effective yield on the
asset. /

• Mudharabah

Income and losses on mudharabah financing are recognized on

an accrual basis if they can be reliably estimated. Otherwise,
income is recognized on distribution by the mudarib. Losses are
charged to income on their declaration by the mudarib.

• Fees and commission income

Income from fees and commission is recognized when earned.

• Rental income

Rental income is recognized based on an accrual basis.

• Dividend

Dividends from investments in equities are recognized when

the right to receive the dividends is established.

• Sukuk

Income is accounted for on a time-apportioned basis over the

term of the sukuk.

• Sale of property

Revenue on sale of property is recognised on the basis of the

full accrual method as and when all the following conditions
are met:
■ A sale is consummated and contracts are signed;
■ The buyer's initial investment, to the date of the financial
statements, is adequate to demonstrate a commitment to
pay for the property; and
336 CIIATlTH 6

■ The bank has transferred to the buyer the usual risks and
rewards of ownership in a transaction that is in substance a
sale and does not have a substantial continuing involvement
with the property.

Revenue on sale of apartments is recognized on the basis

of percentage completion as and when all of the following
conditions are met:

■ A sale is consummated and contracts are signed;

■ The buyer's investment, to the date of the financial

statements, is adequate to demonstrate a commitment to
pay for the property;

■ Construction is beyond a preliminary stage, that is,

commencement of design work or construction contract or
site accessibility, etc.;

■ The buyer is committed;

■ The buyer is unable to obtain a refund for non-delivery of

the unit;

■ The likelihood of the bank being unable to fulfil its

contractual obligations is remote; and

■ The aggregate sale proceeds and costs can be reasonably

estimated.

Apart from the standards issued by international accounting

organizations or by organizations which have authority in particular
countries, some Islamic banks have to comply with the revenue
recognition method of financial authorities which regulate and
supervise the banks. For example, the revenue recognition method
issued by the Central Bank of Iran is as follows:

1. Hire purchase: Income from hire purchase transactions is

recognized when payment is received.
OPERATIONAL ASPECTS AND PRACTIC IIS Of ISLAMIC BANKING SYSTEM 337

2. Instalment sale: The income is credited into the receivable income

account and is recognized when the term is due.

3. Civil partnership: Income is recognized at the end of the contract

term. .

4. Mudharabah: Income is recognized at the end of the contract

term.

5. Futures transaction: Income from both cash sales and credit sales
is recognized with the latter as instalment sale.

6. lo'alah: Income is recognized on a cash basis.

7. Debt purchase: Income is recognized on an accrual basis.

8. Masaqat and mozaraah: Income is recognized on a cash basis.

9. Gharz-al-hassanah: Commission is recognized on an accrual

basis.

10. Direct investment: Income from the sale of shares is recognized

when the sale is completed while dividends are recognized
when received.

The Central Bank of Iran also established the following method for
income and other expenditure streams:

(i) Income obtained from operations performed in conformance

to past banking laws is recognized on an accrual basis.

(ii) Profit and commission for on-going transactions are recognized

on a cash basis.

(iii) Commission for the maintenance of government accounts,

bonuses for bonds and profits obtained through reserves are
recognized on a cash method on the basis of the resolution of
the Council for Money and Credit.

(iv) Interests received from agents and foreign banks are

recognized as income based on an accrual method. Interests
338 CHAPTER 6

received by current accounts from agents of foreign banks,

secured loans issued by Hamburg branches and capital
provided by Hong Kong branches are recognized as income on
a cash basis. Commissions from foreign exchange operations,
administration fees to Iran-Egypt Development Bank and
commissions from the sale of mortgage notes or bills of
exchange and trade bills are recognized on the cash method.

(v) Profit paid to investment accounts, gifts paid to the

gharz-al-hassanah account and interests paid to foreign currency
fixed deposits are recognized as expenditure on an accrual
method. Interests paid to foreign agents due to debit balance
and the commissions paid are recognized as expenditure on a
cash method.

in addition to the standards issued by international accounting

organizations, some Islamic banks such as Jordan Islamic Bank
are also required to comply with the laws of their establishment.
For Jordan Islamic Bank, the law outline the revenue recognition
methods for the bank, which are provided in Section 18 and
Section 19 as follows:

Section 18:

Profit or loss associated with joint financing and investment

activities must be recorded in separate accounts and must
be presented separately from the income and expenditure
associated with activities and services received by the bank.
Tile same treatments apply to investment income and
expenditure for specific purposes, whereby an account must be
maintained for each project.

Section 19:

In accounting for the profit related to its financing and

investment activities, the bank is not allowed to use accounting
methods based on estimated or expected profits. On the other
OPERATIONAL ASPECTS ANO PRACTICES OI ISLAMIC HANKING SYSTEM 339

hand, the accounting must be subject to the profits which are

recognized according to the financing method provided by the
bank and which conforms to the following regulations:

(i) In the mudharabah method, profit must be recognized

on the basis of the latest solution of the account which is
executed between the bank and the party utilizing the fund.
The solution must be based on the actual amount of money
received and tire recognition of the income. The solution
must also be approved and received in full. Yearly profits
must be credited into the account in that particular year,
whereby solution is implemented regardless of whether the
project is fully or only partly completed.

(ii) In the diminishing participation method, profit or income

must be recognized on the basis of net income received
by the project up until the end of the financial year, even
if the income is not received in the form of cash. In such a
situation, the recognized income will be regarded as money
which is supposed to be acquired, or receivables.

(iii) In the method of purchasing for another party at an agreed

mark-up profit, the profit will be recognized on the basis of
the completion of the subsequent contract as well as on the
difference between the actual cost and the price agreed by
the party instructing the purchase.

(iv) All expenditure and costs related to the various operations

of financing must be matched with each particular operation
itself and cannot be incurred on or regarded as general
expenditure issued by the bank.

Investment
Investment is one of the methods used by Islamic banks to generate
revenue. There are four types of investment lhat Islamic banks can
340 CHATTER 6

undertake, namely, purchase of negotiable securities such as shares,

bonds, government issue notes and negotiable deposit certificates;
investment in subsidiary and associated companies; investment
in properties or real estates; and lastly, other investments.
The policy chosen to record the investment undertaken will
influence the investment value reported in the financial statement.
If the investment value increases and this value is not reported, then
the reported value of the company will be lower than the actual
value. Similarly, if the recent value of the investment is lower than
the value at die time the investment is made and this reduction is
not reported, this will have the effect of overvaluing the true or
actual value of the company. This investment process is not clearly
detailed by AAOIFI; it only states that investment must be recorded
at cost less the provision for any permanent diminution in value.
The explanation on investment made by Bank Islam Malaysia
is almost similar to those of Bank Muamalat Malaysia. Bank
Islam Malaysia, in its 2008 annual report, offered the following
explanation on the accounting policy in investment (Bank Islam
Malaysia, 2008, p. 92):

• Securities are classified as held-for trading it they are acquired or

incurred principally for the purpose of selling or repurchasing
in the near term or if they are part of a portfolio of identified
securities that are managed together and for which there is
evidence of a recent actual pattern of short-term profit-taking.
These securities are stated at fair value and any gain or loss
arising from a change in the fair value will be recognized in the
income statement.

• Securities available-for-sale are securities that are not classified

as held-for-trading or held-to-maturity. These securities are
measured at fair value. Investments in equity instruments that
do not have a quoted market price in an active market and whose
fair value cannot be reliably measured are stated at cost.
orr-KATiONAi AsricTs ano practices of Islamic ranking sisiim 341

• Securities held-lo-maturity are securities that have fixed or

determinable payments and fixed maturity and the bank has
the positive intention and ability to hold to maturity. These
securities are measured at amortized cost using the effective
profit method. Gain or loss is recognized in the income
statement when the securities are derecognized or impaired, as
well as the amortization of premium and accretion of discounts.

Investment pojicv differs between banks. For instance, Kuwait

Finance House regards securities as investments which are ready to
be sold and are evaluated at cost. Dubai Islamic Bank, on the other
hand, provides an explanation of fair values for different types of
investment activities in its notes to the accounts. If an investment
is traded in an organized financial market, the fair value is simply
the quoted market price at the close of business on the date of the
balance sheet. For the unquoted investments, the fair value is the
market value of similar investments. Meanwhile, for investment in
properties, the fair value is determined periodically based on the
valuations of independent professional valuators.
Shamil Bank of Bahrain describes in detail the value assigned to
each investment made, as follows (Shamil Bank, 2007):

• Investments in leasing

Investments in leasing (ijarah) are stated at cost and are reduced

according to the bank's depreciation policy for property and
equipment or lease term, whichever is the lower.

• Investments in sukuk

Investments in sukuk are carried at amortized cost, less provision

for impairment in value. The resulting difference is recognized
in the consolidated statement of income.

• Investments held for trading

These investments are initially recognized at cost and

subsequently re-measured at their fair value.
342 CHATTER 6

• Investments in property

Investments in real estate are initially recognized at cost and

subsequently re-measured at fair value.

• Investments available for sale

Investments available for sale are re-measured at fair value.

• Investments in associated companies

Investments in associated companies are carried in the balance

sheet at cost plus post-acquisition changes in the bank’s share of
net assets of the associate.

• Mudharabah investments

Mudharabah investments are initially recorded at cost and

subsequently re-measured at fair value.

Provision for Doubtful Debts

Doubtful or bad debts are unavoidable in the banking industry.
Although Syariah makes it mandatory for Muslims to pay their
debts, in practice Islamic banks are haunted bv bad debts. For this.
AAOIFI has suggested that Islamic banks present four matters
related to doubtful debts, as follows (AAOIFI. 2000, p. 91):

(i) Provision charged to income statement during the period.

(ii) Receivables written off during the period.

(iii) Receivables collected during the period which were previously

written off.

(iv) The balance of the allowance for doubtful receivables as of the

beginning and end of the period.
 OPERATIONAL ASPECTS AND PRACTICES Of ISI AMIl BANKING SYSTEM 343

Islamic banks in Malaysia and Indonesia, Kuwait Finance House,

Dubai Islamic Bank, Albaraka Turk and Islamic International Arab
Bank are among those that disclose their provision for doubtful
debt policies. Although Islami Bank Bangladesh and Shamil Bank
of Bahrain do not specify any policy regarding this matter, they do
provide a certain sum as provision for doubtful debts. Generally,
there are two types of provisions created by Islamic banks, namely
general and specific provisions. General provision is based on a
percentage of the loan portfolio and covers possible losses which are
not specifically identified. Specific provision is made for doubtful
loans which have been individually reviewed and specifically
identified as bad and doubtful. The following are examples of
policies related to the provisions of doubtful debts as practised by
Bank Muamalat Malaysia (Bank Muamalat. 2007, p. 64):

• Specific allowances are made for doubtful debts which have

been reviewed individually and specifically identified as
substandard, doubtful or bad.

• General allowances are also provided based on a percentage

of the financing portfolio to sustain losses which cannot be
identified specifically. These percentages are reviewed on an
annual basis and adjustments, if necessary', are made to the
overall general allowances. General allowance is also made for
certain high-risk accounts.

• Any uncollectible financing or part of it which is classified as bad

is written off after taking into consideration the realizable value
of collateral, if any, when the management is of the opinion that
there is no prospect of recovery.

• Additional allowances for doubtful debts are provided when

the recoverable amount is lower than the net book value of
financing (outstanding amount of financing, net of specific
allowances) and long outstanding non-performing financing on
the following basis:
344 chatter 6

■ Assigning 50% of the force sale value of the properties

held as collateral for non-performing financing which is
outstanding for more than five years but less than seven
years; and

■ No value will be assigned for the collateral of non-performing

financing which is outstanding for seven years and above.

• Any allowance made during the year is charged to the income

statement.

• During the year, the bank has adopted a more stringent

classification policy on non-performing financing, whereby
financing is classified as non-performing and sub-standard
when repayments are in arrears for more than three months
from the first day of defaults or after maturity date.

• The bank has also adopted a more stringent basis for specific
allowances on non-performing financing by making 20"..
specific allowance on non-performing financing which are
more than 5 months in arrears, 50% for non-performing
financing in arrears of 8 months and 100% for non-performing
financing in arrears of 11 months and above.

Fixed Assets and Depreciation

Fixed assets are assets bought for the generation of revenue. These
fixed assets are usually in the form of buildings, motor vehicles,
office equipment and management information system. AAOIFI
does not provide detailed guidelines on policy related to fixed
assets. There is no guideline pertaining to the assigning of value
except for matters related to depreciation The fixed assets are
presented as notes to the account. Among the banks which report
their policies on fixed asset accounting are Bank Islam Malaysia,
Shamil Bank of Bahrain, Islami Bank Bangladesh. Bank Muamalat
 Ori nATIONAL ASPECTS AND PRACTICES Ol' ISLAMIC BANKING SYSTEM 345

Indonesia, Albaraka Turk, Islamic International Arab Bank,

Kuwait Finance House and Dubai Islamic Bank, The policy related
to fixed assets practised by Bank Islam Malaysia is as follows
(Bank Islam Malaysia, 2008, p. 93);

• All items of property and equipment are stated at cost less

accumulated depreciation and impairment losses, if any.

• Property and equipment which are no longer in active use and

are held for disposal are stated at the carrying amount at the
date when the assets are retired from active use, less impairment
losses, if any.

• Costs include expenditures that are directly attributable to the

acquisition of the asset and any other cost directly attributable
to bringing the asset to working condition for its intended
use. and the cost of dismantling and removing the items
and restoring the site on which they are located. The costs of
self-constructed assets also include the cost of materials
and direct labour. Purchased software that is integral to the
functionality of the related equipment is capitalized as part of
that equipment. When significant parts of an item of property
and equipment have different useful lives, they are accounted
for as separate items (major components) of property and
equipment. Gain or loss on disposal of an item of asset is the
difference between the net proceeds from disposal and the
net carrying amount of the asset and is recognized in "other
income" in the income statements.

• The cost of replacing part of an item of an asset is included in

the carrying amount of the asset only when it is probable that
the future economic benefits embodied within the part will flow
to the bank and the cost of the item can be measured reliably.
The earning amount of the replaced part is derecognized.
The cost of the day-to-day servicing of property and equipment
are recognized in the income statement as incurred.
346 CHATTER 6

• Management information system development costs and

work-in-progress are not depreciated until the assets are ready
for their intended use. The straight-line method is used to
write off the costs of the other assets over the term of the
estimated useful lives. The estimated useful lives for the
current and comparative periods are six years for building
improvement and renovations; two to six years for furniture,
fixtures, fittings and equipment; and four years for motor
vehicles. Depreciation methods, useful lives and residual values
are reassessed at the reporting date.

• Long-term leasehold land is not amortized. Leasehold land with

tenure of less than 50 years is amortized in equal instalments
over the period of the respective leases. Management
information system development costs and work-in-progress
are not depreciated. Leasehold land that normally has an
indefinite economic life and whose title is not expected to be
passed to the lessee by the end of the lease term is treated as
an operating lease. The payment made on entering into or
acquiring a leasehold land is accounted for as prepaid lease
payments. On adoption of FRS (Financial Reporting Standard)
117, Leases, the bank treats such a lease as an operating lease,
with the unamortized carrying amount classified as prepaid
lease payments in accordance with the transitional provisions
in FRS 117.67A. The prepaid lease payments are amortized on a
straight-line basis over the lease term.

Some Islamic banks state their fixed assets at cost less

accumulated depreciation. Depreciation is computed based on the
straight-line method at annual rates. Albaraka Turk states that
the costs of repairs are capitalized if the expenditure increases the
economic life of the asset. For Dubai Islamic Bank, depreciation is
computed using the straight-line method based on the estimated
useful lives of the fixed assets.
 OfEKATlONAI. ASPIC TS AND I'RACTICIS OI ISI AMIC HANKING SYSTEM 347

Allocation of Profit

One of the special features of Islamic banks is the application

of the profit-loss sharing principle in their transactions. Unlike
conventional banks, depositors of Islamic banks do not know in
advance returns from their deposits. This is because most of the
deposit facilities offered by Islamic banks are based on the concept
of mudharabah. AAOIFI's guideline provides no clear suggestion
on the allocation of profit. Tire guide merely states that Islamic
bank, when conducting its task as manager of the investment
funds deposited by customers, will receive returns in the form of
a percentage of the profit. Islamic banks that clarify the method of
profit allocation between the depositors and the bank are Kuwait
Finance House, Islamic International Arab Bank and Islami Bank
Bangladesh. Dubai Islamic Bank only states that allocation of profit
is calculated according to the bank’s own standard procedures
and is approved by the bank's own Syariah Supervisory Board.
Shamil Bank of Bahrain, on the other hand, gives a general
description of the profit allocation between investment account
holders in its annual report.

Payment of Zakat
The obligation to pay zakat is another unique feature of Islamic
banks. AAOIFI has recommended that payment of zakat be stated
when a particular bank is responsible for the payment of zakat on
behalf of its owners. In addition, if the bank provides services for
mobilizing and distributing zakat, then the report must be presented
in a separate statement. Most Islamic banks state their policies on
payment of zakat except for those in Turkey. Islami Bank Bangladesh
does not mention any policy on zakat, but does implement payment
of zakat and it is regarded as one of its operational expenses.
This method is also practised by several banks in Sudan.
348 CHATTER 6

According to Bank Islam Malaysia, its zakat payment is in

accordance with Syariah rules and is as approved by the
Syariah Supervisor}' Board Most banks in the Middle East assert
that zakat is the responsibility of shareholders and not the banks.
For instance, Islamic International Arab Bank and Kuwait Finance
House clearly state that zakat must be borne by the shareholders
and depositors, independently. The banks are not responsible for
the collection of zakat on their behalf. However. Kuwait Finance
House assesses the zakat that needs to be paid by the shareholders
according to the method set by its Syariah Supervisory Board. Dubai
Islamic Bank is the only bank which presents a complete description
of zakat payment. It states that zakat is computed as per the articles
and memorandum of association of the bank and approved by
the Fatwa and Syariah Supervisory Board, on the following basis
(Dubai Islamic Bank, 2007, p. 20):

• Zakat on shareholders’ equity is deducted from their dividends

and is computed on their zakat pool (shareholder's equity less
the paid-up capita), donated land reserve and cumulative
charges in fair value) plus employees’ end of service benefits.

• Zakat on profit equalization provision is charged to this provision

after computation is made.

• Zakat is disbursed by a committee appointed by the Board of

Directors and operating as per the by-law set by the Board.

• Zakat on paid-up capital is not included in thezakat computations

and is payable directly by the shareholders themselves.

Other Policies

Apart from the important policies discussed above, there are

also practices that differ from one Islamic bank to another. The
initiatives taken by AAO1FI to handle this matter are commendable
as the organization has successfully developed standard guidelines
 OrEKATIONAI. ASPECTS AND PRACTICES OF ISLAMIC BANNING SYSTEM 34**

for the preparation and presentation of financial statements of

Islamic financial institutions. However, since AAOIFI is not a
legislative organization, Islamic banks are not obliged to comply
with or adhere to the recommendations made. As a result, there
are differences in the preparation and presentation of financial
statementsoflslamicbanks. Adistinctiveexample is the presentation
of deposit services under the mudharabah principle. This deposit is
removed from the balance sheet by some banks as it is not regarded
as a liability. In cases where financing is based on the principle of
profit-loss sharing, it is the practice of some Islamic banks to jointly
bear the administration expenses and other general expenditure
with depositors. Therefore, profits distributed to the depositor
would be based on net profit after deducting all expenses. Banks
which are practising this method include Kuwait Finance House
and Dubai Islamic Bank. In contrast, all administration expenditure
is fully borne by the bank (shareholders) in the case of Bank Islam
Malaysia and Jordan Islamic Bank.

RISK MANAGEMENT

Financial institutions are in the business of risk management and

reallocation. Globalization and financial liberalization compounded
by the explosion of technological capabilities have exposed banks
to greater and more risks. There are three main categories of risk
that banks are exposed to, namely credit risk, market risk and
operational risk.
Credit risk is closely tied to default borrowing or contractual
obligation. Market risk is the exposure to uncertain market
conditions which reduce the value of investment or portfolio.
Operational risk is the result of uncertainties regarding the actual
operations of a bank including failed internal processes as well
as people and system failure. In 1988, the Bank for International
350 CHATTER 6

Settlements (BIS), an organization established in 1930 with the

original objective of facilitating the settlement of payments
between banks, published a set of minimal capital requirements
for banks known as Basel I which required banks to hold capital
equal to 8% of their risk-weighted assets. Under this framework,
credit risk and market risk can be measured to determine capital
requirement sufficiency. Since 1988, many changes have taken place
in the banking environment including risk management practices,
supervisory approaches and the financial market landscape. Taking
into consideration operational risks, apart from the credit risks and
market risks that banks face, a new international standard ensuring
that banks hold sufficient capital reserves was published. The new
framework, Basel II, is the continuation of Basel 1 and has been fully
implemented by all member countries as at end of 2006. Islamic
banks are also expected to comply with the requirements stipulated
under Basel II. There are three principal pillars in Basel II, namely:

(i) Minimum capital requirements

(ii) Supervisory committee

(iii) Market discipline

Under Basel II, the 8''/.. capital requirement of Basel 1 still holds,
but not the method of risk computation. In the initial framework,
only credit risk and market risk were given due recognition
while operational risk was regarded as part of these risks faced
by banks. However, the new framework attaches importance to
operational risks and thus requires banks to include operational
risk measurement in calculating the minimum capital requirement
level. Hence, the first pillar of the new accord requires banks to
assess their market and operational risk and provide capital to cover
such risk. By aligning the minimum capital requirements more
closely with a bank’s actual exposure to credit and operational risk,
Basel II framework’s explicit incentives in the form of lower capital
requirements allow banks to adopt more accurate measures of risk
 OPERATIONAL ASPECTS AND PRACTICES OF ISLAMIC HANKING SYSTEM 351

and more effective processes of controlling their exposure to risk.

The new capital framework also recognizes the necessity to exercise
effective supervisory review of banks' internal assessments of their
overall risks. The third pillar leverages on the ability of market
discipline to motivate prudent management by promoting greater
transparency through the banks' public disclosures.
Almost all Islamic banks have reported their risk management
policy. Nonetheless, no uniformity in the reports could be
established. For example, Jordan Islamic Bank touched only on its
credit risk and market risk management. Shamil Bank of Bahrain
only reported on credit risk, while Albaraka Islamic Bank of Bahrain
reported on liquidity risk and profit-loss sharing risk. Dubai Islamic
Bank categorized risk into credit risk, market risk, profit rate risk,
currency risk and liquidity risk. Compared to Islamic banks in the
Middle East, Islamic banks in Malaysia and Indonesia presented
more comprehensive information regarding their risk management
practices. Risk management of Bank Muamalat Indonesia includes
liquidity' risk, operational risk, legislation risk, reputational risk,
strategic risk and compliance risk.
Bank Islam Malaysia, Bank Muamalat Malaysia, Qatar
Islamic Bank, Kuwait Finance House, Albaraka Turk and Islamic
International Arab Bank are among those Islamic banks that publish
the types of risks and their associated risk management practice
as well as their risk management structure. This enables users of
the financial statement to compare the banks’ risk management
with that of others. The following explains the risk management
practices adopted by Bank Islam Malaysia (Bank Islam Malaysia,
2008).

Market risk. Market risk is the loss arising from adverse movements
in market variables such as rate of return risk, foreign exchange
rate risk, displaced commercial risk, equity investment risk and
commodity risk.
352 < inrri R 6

Credit risk. Credit risk arises from loss of revenue and capital as
a result of the inability to meet the terms of a contract by the
customer of counter parties through financing, dealing and
investment activities.

Liquidity risk. Liquidity risk refers to the potential inability of the

bank to meet its funding requirements arising from cash flow
mismatches at a reasonable cost.

Operation risk. Operation risk is risk of loss resulting from

inadequate or failure of internal processes, people, systems and
external events.

Syuria/i-compliance risk. Syanah-compliance risk refers to the

bank's failure to comply with Syariah rules and principles as
determined by the Syariah regulatory bodies of Bank Negara
Malaysia, the Securities Commission and the bank's own
Syariah council.

Board Risk Committee. The Board Risk Committee (BRC) is

responsible for effective functioning of the integrated risk
management of the bank. As a committee of the Board.
BRC acts within its delegated authority to decide on or
recommend to the Board of Directors risk management issues.
Its members comprise two independent non-executive directors
and two non-independent non-executive directors. One of the
independent non-executive directors acts as the committee
chairman.

Some of the main functions of BRC include to review and

recommend risk management strategies and policies to the
Board; to review and propose the setting of the bank's risk
tolerance at enterprise and strategic business unit levels; to
oversee the overall management of all risks covering market risk,
credit risk and operational risk; to approve risk methodologies
for measuring and managing risks; to review the bank's entire
 OPERATIONAL ASPECTS AND PRACTICES OF ISLAMIC HANKING SESIIM 353

risk management processes, systems and internal control; and

to approve contingency plans for dealing with extreme internal
and external events or disasters.

Management Risk Control Committee. The Management Risk

Control Committee (MRCC) is responsible for ensuring that
the policies approved by the Board are properly implemented.
The committee also ensures the effective management of
operational issues. Under the MRCC, there are four sub­
committees, namely Asset and Liability Management
Committee, Operational Risk Control Committee, Credit Risk
Control Committee and Recovery Management Committee.

Risk Management Framework. The Risk Management Framework

(RMF) was formulated with the aim of managing the bank's risks
in a more holistic manner through philosophical and practical
approaches. The methodology of the RMF is based on the concept
of solah (pillar of Islam) which is built upon five elements, that
is niyyah (statement of solah), jama'ah (implementation structure
of solah). syarat (necessary' elements of solah), rukun (essential
activities of solah) and yaedah (facilities required for solah).
All these five elements are adopted in managing the bank's
risks.

SUMMARY

Modem Islamic banking system started with the operations of

Mit Ghamr Savings Bank in the Nile River Valley, Egypt in the
early 1960s. Since then, Islamic banks have mushroomed not only
in Muslim countries but in non-Muslim or Western countries
as well. Islamic banking products are now widely accepted by
both Muslim and non-Muslim customers. This is evident of the
capability of Islamic banks in fulfilling the modem banking needs
of customers but in line with the requirements of Syariah. Islam is
354 (haiti:r6

a universal religion and is founded on belief in Allah (s.w.t.), the

One and Only, and guided by the holy Quran and Hadith. Hence,
it follows that all operations of the Islamic banking system must
be founded on Syariah principles. Nonetheless, the Islamic banking
system is still in need of harmonization as there exist differences
in Syariah practices among Islamic banks in their business
transactions. These differences are translated into differences in the
characteristics of the products and services offered. Basically, the
financial products and services offered by Islamic banks are similar
to those of the conventional banks, particularly in terms of deposit
facilities, financing and other services. Almost all Islamic banks
offer deposit facilities such as current account, savings account and
investment account. The only difference is in terms of the added
value each product offers. The same applies to financing facilities.
Differences which may occur in terms of the amount of deposit
made by customers and the type of financing given priority by a
particular bank, are due to the differences in the economic, social
and cultural factors among the Muslim countries where the banks
operate. Consequently, disparities also arise in terms of financing
concentration, methods in managing fund and services provided.
The most apparent differences lie in the usage of Syariah
principles upon which a bank's modes of financing are based, and
the bank’s views on the types of social activities to be conducted.
Although profit-loss sharing modes of financing are preferable, the
practices ot most Islamic banks indicate otherwise. Furthermore,
a majority of financing facilities are granted to less risky sectors
in the economy. Some Islamic banks are very committed with
regard to social responsibility while others are found to be moving
in tandem with conventional banks while not violating Syariah.
In terms of developing a standardized financial recording and
reporting model for Islamic banks, the role ot the Accounting and
Auditing Organization for Islamic Financial Institutions (AAOIFI)
in this matter should be commended. Unfortunately, the standards
recommended by AAOIFI are not legally binding, and banks can
 ori KAI IONAL ASFtCTS ANO FKAC1II IS OI ISLAMIC BASKING SISTLM 355

opt not to adopt or comply with these standards. As a result, most

banks are more inclined to comply with recommendations of
international accounting organizations or the authorities in their
respective countries. Consequently, no uniformity in the financial
statement presentations among the Islamic banks exists.
As with conventional banks, Islamic banks have started to place
importance on risk management. The practice of risk management
has become even more critical as Islamic banks are now required to
comply with the Basel 11 framework. Risks associated with Islamic
banks include credit risk, profit-sharing risk, market risk, liquidity
risk and operational risk. Theoretically, if the internalization
of Islamic values is high among the users of Islamic banking
services, the risks involved would naturally be lower compared
to conventional banking since the debtor is obligated by religion
to pay back all of his debt and thus effectively reducing credit
risk. Furthermore, there would not be any risk related to deposit
withdrawal as customers would have deposited with the bank for
religious reasons and hence would not be motivated by high returns
on deposits. Operational risk, which is now given importance under
Basel II. should very rarely arise because Islamic work ethics would
guide the bank workers to be trustworthy, efficient and meticulous
in performing their duties.

REFERENCES AND FURTHER READING

AAOIFI. Accounting, Auditing and Governance Standards for Islamic

Financial Institutions. Bahrain: The Accounting and Auditing
Organization for Islamic Financial Institutions, 2000.

AIBaraka Islamic Bank of Bahrain. Annual Report (various issues).

Albaraka Turk. Annual Report (various issues).

356 CHAPTtK 6

Aryan, Hossein. "The Impact of Islamization on the Financial

System." In Islamic Financial Markets, edited by Rodney Wilson,
155-170. London and New York: Routledge, 1990.

Baldwin. David. "Turkey: Islamic Banking in a Secularist Context."

In Islamic Financial Markets, edited by Rodney Wilson, 33-58.
London and New York: Routledge, 1990.

Bank Asya. Annual Report (various issues).

Bank Islam Malaysia Berhad. Annual Report (various issues).

Bank Islam Malaysia Berhad. Bank Islam. Penub/ilian Jan Operas/.

2nd ed. Kuala Lumpur, 1989.

Bank Meili Iran. Annual Report (various issues).

Bank Muamalat Indonesia. Annual Report (various issues).

Bank Muamalat Malaysia Berhad. Annual Report (various issues).

Bank Syariah Mandiri. Annual Report (various issues).

Dubai Islamic Bank. Annual Report (various issues). United Arab

Emirates.

El Gharb Islamic Bank of Sudan. Annual Report (various issues).

Faysal Islamic Bank of Bahrain. Annual Report (various issues).

Haron, Sudin. Principles and Operations of Islamic Banking. Selangor

Darul Ehsan (Malaysia): Berita Publishing, 1996.

Islami Bank Bangladesh Limited. Annual Report (various issues).

Islamic Bank of Bahrain. Annual Report (various issues).

Islamic International Arab Bank. Annual Report (various issues).

Jordan Islamic Bank. Annual Report (various issues).

OFEUATIONAL ASPECTS ANO PRAC TICES OF ISLAMIC HANKINC. SVST1 M 357

Karim, R.A.A. "Standard Setting for the Financial Reporting

of Religious Business Organizations: The Case of Islamic
Banks." Accounting and Business Research. Vol. 20, No. 80 (1990):
299-305.

Kuwait Finance House. Annual Report (various issues).

Muslim Commercial Bank. Annual Report (various issues).

Qatar Islamic Bank. Annual Report (various issues).

Shallah, Ramadan. "Jordan: The Experience of the Jordan Islamic

Bank." In Islamic Financial Markets, edited by Rodney Wilson,
100-128. London and New York: Routledge, 1990.

Shamil Bank of Bahrain. .Animal Report (various issues).

Turkiye Finans. Annual Report (various issues).

www.bis.org.
 CHAPTER

ISLAMIC FINANCIAL MARKETS

This chapter discusses the development of the Islamicfinancial markets, the

financial instruments which have been created and how they are transacted.
The discussion also covers the Islamic financial markets in Malaysia and
the authorities involved because the Malaysian Islamic financial markets
are at the forefront in terms ofgrowth as well ns breadth and depth.

INTRODUCTION

In the early stages of their establishment, the focus of Islamic banks

was on providing various deposit and financing facilities which
were riba-free. The overwhelming support from Muslim depositors
resulted in an extraordinary liquidity problem for Islamic banks. In
many cases, the banks' funds could not be mobilized and remained
idle because of limited investment opportunities since they are
restricted from channelling these funds into interest-based financial
instruments. Consequently, Islamic banks were unable to invest
the excess funds and reap returns from their investment In the

359
360 C HAITI R 7

conventional system, however, a mechanism that allows surplus

banks to loan out their excess funds to deficit banks exist. Various
financial instruments are also available to the surplus banks to
invest any excess funds they have.
In light of the problems facing Islamic banks, the global Islamic
banking system viewed that having its own financial markets was
essential for further growth. In principle, the financial market is the
meeting place of two parties with mutual needs - one partv- requires
funds to support its financial needs, and the other has unused
surplus funds which it intends to invest for the purpose of attaining
returns or income. Realizing the existing problems, intellectuals
directly involved in Islamic banking system began to put their
thoughts into how an Islamic financial market could be created and
the form of mechanism required. Islamic financial instruments also
needed to be developed as alternatives to the conventional ones.
These financial instruments must, however, possess the following
features of conventional financial instruments:

(i) They must be negotiable, that is, it must be easy to transfer the
ownership of the instruments from one holder to another.

(ii) They must be liquid, that is. they may be easily sold when cash
is required.

(iii) They must carry minimum risk.

(iv) They must be easily valued and priced.

Due to the fact that Islamic financial markets are at a developing

stage, these new concepts have raised many theoretical and practical
questions. The issue of religious rules (hukum) also sometimes
causes confusion and continuous debate not only among the local
intellectuals but also between countries.
 ISLAMIC FINANCIAL MARKETS 361

TYPES OF FINANCIAL MARKET

Conventional financial market is made up of four components,

namely capital market, money market, futures market and
mortgage market. The capital market trades in instruments with
an original maturity of more than one year. Money market deals
in short-term financial instruments whose maturity period is one
year or less. The forward and future market involves a contract
between two parties for future delivery of currencies, securities or
commodities. Mortgage market covers real estate financing (e.g.
financing of homes, buildings and other properties). Although
these are the common financial market components frequently
discussed in text books, another financial instrument with a unique
transaction mechanism is becoming increasingly popular in wealth
mobilization. This mechanism is referred to as unit trust. Unit trusts
are open-ended investments and they offer access to a wide range
of securities.
The four componentsof the financial market need not necessarily
exist in al) countries of the world. With the exception of developed
countries, the existence of these components depends to a large
extent on a country's level of economic development.

Capital Market
Capital market is the place where long-term financial instruments
with maturity exceeding one year are issued and traded. The
principal goal of establishing this market is to channel savings
into long-term productive investments. Participants in this market
comprise those from the government and private sectors. In the
conventional market, the financial instruments issued and traded
are those issued by the government as well as bv the private sectors.
The government is defined as the authorities comprising the federal
362 CHATTER 7

government, state governments, local authorities and government

agencies, These authorities would in certain instances use the
capital market either to obtain funds Io finance administration and
development expenses, or to invest any surplus funds. The private
sector comprises giant companies, medium and small companies,
as well as individuals.
The financial instruments in the capital market may be
categorized into equity instruments and debt instruments. Equity
instruments are in the form of share certificates, either common or
preferred stocks. Debt instruments are made up of bonds which
may be classed into common bonds and convertible bonds The
main difference between stocks and bonds lies in their payment
of returns (either in the form of dividend or interest) to the owner
or holder. For a person who holds shares of a company, there is no
guarantee that he shall receive annual dividends since the company
has no legal obligation to pay dividends to shareholders. Payment
of dividends depends only on profits and it is the Board of Directors
who determines whether or not to pay dividends to stockholders.
On the other hand, when bonds are issued, the company is bound by
law to pay annual interest in accordance with the terms made at the
time of the issuance. If the company fails to pay interest as promised,
it may face legal actions from the bondholders. Furthermore, this
clearly suggests that the company is facing financial problems.
In Malaysia, any company doing business or wishing to do
business in the country must be registered with the Companies
Commission of Malaysia under the Companies Act 1965 The
owner and the company are two separate entities. The relationship
between the owner of the company and the company itself depends
on the amount and types of shares held Although shareholders are
legally the rightful owners of the company, it does not mean that
they are responsible for all actions undertaken by the company.
Shareholders are also not responsible for the company's debts.
However, in case of liability claim on the company, the amount is
limited to the value and total shares owned.
 ISLAMIC FINANCIAL MARKETS 363

The difference between common stock and preferred stock

rests on dividend payment. Unlike common stock, the payment
of dividends for preferred stock is usually in the form of a fixed
percentage and it takes priority' over common stock dividends.
For common stock, dividends paid depend entirely on the discretion
of the Board of Directors. In addition, preferred stockholders
have a claim prior to common stockholders on the company's
assets. Preferred stock is of two types, namely cumulative and
non-cumulative. Cumulative stock accords the holders a continuous
claim on the dividends. Hence, any unpaid dividends will be
accumulated until the company resumes paying them. As such,
cumulative stockholders are entitled to all past and present
dividends. On the contrary, non-cumulative preferred stockholders
only receive dividend in the current year. Non-cumulative preferred
stock does not confer any claims on missed dividends.
The central point in the issuance and transaction of stock is
the concept of limited liability, whereby the stockholder's financial
liabilty is limited to the amount he has invested in tire event that the
business incurs a loss. He is not personally liable for the company's
debt other than the value of his investment. This concept of limited
liability is actually related to the miiitharuhih principle in Islam,
whereby the enterpreneur is neither held responsible for the loss
incurred by tire business nor is he required to replace the owner's
capital should such a loss incurred under the condition that the
loss is not due to his carelessness or negligence. However, issues
of relevance between the owner and the company such as in the
context of conventional company legislation are not mentioned
anywhere in the original source of Islamic fu/h (jurisprudence) and
were never discussed by Muslim scholars and uluinii (Usmani, 1992).
Nevertheless, Muslim scholars believe that the concept of limited
liability is closely related to the concept of "juridical person" or
separate entity. Given that Syariah accepts the concept of juridical
person, it is thus permissible for Islamic banks to deal with stocks
and shares.
3M CHAirra 7

Since stocks represent a financial claim or is a title of ownership,

these certificates do not constitute money. Hence, the negotiation
and transfer of ownership pertain only to the object of the certificate
and not the certificate itself which is regarded from the legal point
of view as a proof of the claim. Under Syariah, common ownership
is permissible and therefore it is legal to undertake sales, pawning
or donation. During the process of buying and selling stocks, what
changes is only the ownership right, and it is this exchange of value
that is paid using cash or other modes of payment.
In contrast to common stock, preferred stock cannot be bought
by Muslims and Islamic banks. This is because preferred stock
is associated with a pre-determined fixed rate of return which is
prohibited by Syariah. However, as an alternative, Muslim scholars

a preference dividend based on a pre-determined profit ratio. Since

what is specified is only the profit ratio and not a fixed payment,
the preferred stocks based on this concept do not contradict Syariah
(Mannan, 1990). This simply means that preferred stockholders
do not know the amount of annual dividends to be received and
dividends are based on the profits made by the company Hence,
large profits are translated into high dividends for stockholders.
This view was researched and reviewed by the Syariah Advisor)’
Council of the Securities Commission of Malaysia. The Council, in
its 20th meeting on 14 July 1999, put forward a resolution that
non-cumulative preferred shares be allowed by Syariah by applying
the concept of tanazul (to drop claims to rights). The application of
this concept is based on the agreement of the common stockholders
during tlie general meeting to commit tanazul for the issuance
of preferred stocks. Subsequently at even- general meeting, the
common stockholders would also commit tanazul in order to grant
dividends to preferred stockholders based on the percentage of net
profit obtained by the company. This means that the percentage of
return to preferred stockholders is based on profit and not the face
value of the preferred stocks. The amount of returns received by
 ■SI AMIC FINANCIAL MARKETS 365

individual investor is in turn based on tire amount of stocks held.

Due to the fact that the issuance and distribution mode of returns
are based on profit, the mudharabah principle is the most appropriate
Syariah principle to be used as the basis for stock issuance. Besides
the requirement to comply with positive laws and other regulations
as determined by monetary authorities, there are other matters that
must be adhered to for the issuance of stocks to be Syarmh-compliant.
Similar to any ordinary public offering, a prospectus describing the
financial and rion-financial aspects of the company will have to be
provided to potential investors. Among the important information
that should be stated are:

(i) Investors must be aware that the contract is governed by the

principle of mudharabah.

(ii) The method of distributing returns to investors must be clearly

stated in the contract. Aspects such as profit ratio, when
dividends will be paid and mode of payment must be stated.

(iii) The purpose of the stock issuance must be clear. One aspect
that is still constraining the application of stocks in the Islamic
capital market is the issue of reselling stocks bought. Before
the money invested by the stockholder can be utilized by the
issuing company, the purpose of the proceeds must be clearly
stated in the contract.

The ulama are of the view that for as long as no investment has been
undertaken, a stock cannot be resold at a higher price during the
period after it is issued and bought. The transactions within this
period is subject to the Syariah rules of disposition of money and
thus it should be sold at its face value. Titus, the prospectus should
specify as to when the stocks are permissible for transactions. Under
current practice, the permissible date is usually concurrent with the
date the stock is listed on the stock market.
Another issue that has stirred much debate among Muslim
scholars is stock market speculation. Islam forbids speculation
366 ciunT.K7

because it involves gambling or maisir. But the issue of speculation

in the stock market has not met with any resolution due to the
difficulty in determining its position. Stockholders' returns from
their investment in stocks are of two types, capital gains and
dividends. Capital gain is profit made as a result of selling stocks
for more than the original purchase price. Dividends, on the other
hand, are the cash distribution of earnings to the stockholder.
Naturally, several questions pertaining to the Islamic capital
market and the trading of stocks arise: Is it allowable by Syariah for
investors participating in the Islamic capital market to sell today
the stocks bought yesterday? Is the buying and selling of stocks
considered gambling? Or is one really buying or selling a certain
right over the company?
Although scholars associate speculation with gambling, this
view is not reciprocated by the Syariah Advisory' Council of the
Securities Commission of Malaysia. At its 10th general meeting
on 16-17 October 1997, this Council ruled that speculation may
be allowed. Although speculation was never discussed by Muslim
jurists, the bai mtaayadah principle may be associated with this
practice. However, Syariah does not allow cheating and manipulation
in the stock market. In addition, there are fatwa which have listed
stocks that are either deemed as permissible or prohibited for
Muslim investors. In Malaysia, the Syariah Advisory Council of
the Securities Commission publishes a list of Syoria/i-compliant
stocks. As at end of November 21X18, a total of 855 Syona/i-compliant
securities listed on the main board, second board and MESDAQ
market were approved by the Syariah Advisory' Council of the
Securities Commission of Malaysia. This represents 85% of the
total securities listed. Synrnili-compliant securities as defined bv the
Council include ordinary shares, warrants as well as transferable
subscription rights.
The three main elements that make stocks non-permissible are
riba, gambling and prohibited products or related products. But
even so, investment is permitted in activities that have tolerable
 ISLAMIC FINANCIAL MARKETS 367

level of mixed contributions from permissible and non-permissible

activities where the non-permissible activities represent only a
small percentage of the activities and do not exceed the benchmarks
established by the Council. For example, the Council has established
four benchmarks for determining the tolerable level of mixed
contributions from permissible and non-permissible activities as
follows (www.sc.com.my):

(i) The 5% benchmark is used to assess the level of mixed

contributions from activities that are clearly prohibited such
as riba, gambling, liquor and pork.

(ii) The 10% benchmark is employed to assess the level of mixed

contributions from the activities that involve the element of
umuin balwa (common plight and difficult to avoid) such as
interest income from fixed deposits in conventional banks.
This benchmark is also used for tobacco-related activities.

(iii) The 20% benchmark is applied to assess the level of

contribution from mixed rental payment from non-compliant
Syariah activities including rental payment from premises that
are involved in gambling, sale of liquor, etc.

(iv) The 25% benchmark is used to assess the level of mixed

contributions from the activities that are generally permissible
according to Syariah and have an element of maslahah (public
interest), but there are other elements that may affect the Syariah
status of these activities. Examples of such activities include
hotel and resort operations, share trading, stockbroking and
others; these activities may also involve other activities that
are deemed as non-permissible according to Syariah.

In contrast to stocks, conventional bonds are prohibited as they

represent interest-based funding. There are various types of bonds
in the conventional capital market which are normally issued by
the corporate sectors to obtain funds, namely mortgage bonds.
368 CHATTER 7

debenture bonds and subordinate debentures. Mortgage bonds

are normally issued with maturities of between 20 and 40 years.
They give the bondholders first claim on some or all of the issuing
company's assets in the event of default. The maturity period of
debenture bonds is typically up to 25 years. Unlike mortgage
bonds, these bonds are secured by assets and in terms of priority
they are ranked after mortgage bonds. Subordinate debentures
are also known as convertible bonds because they are issued as
loans and the issuing company pays a fixed annual interest rate
to the bondholders. Upon maturity, the holders have the choice to
convert them into common stocks. Therefore, until such conversion
they are considered long-term debts and the issuing company is
contractually obligated to pay interest and principal payments.
In the early stages of Islamic banking in Malaysia, there were
not many financial instruments in the form of debt certificates
issued by the authorities or the government and corporate bodies
which could be subscribed to by Islamic banks. However, the
government of Malaysia through its central bank. Bank Negara
Malaysia, issued debt certificates that may be subscribed or bought
by Islamic banks under the yard hassan principle. The certificate,
known as Government Investment Certificate, was issued to
provide an opportunity to Bank Islam Malaysia to invest its surplus
funds. The bondholder was given gift or liibah every year-end at a
pre-determined rate. This commitment of the government in issuing
bonds which are Si/aria/i-compliant continues to this day. As at end
of September 2008, the size of Islamic bonds issued in Malaysia was
RM37.66 billion which represented 44.9% of total bonds issued in
the country. Meanwhile, the amount of sukuk outstanding for the
same period was RM 146 billion.
One suggestion made by Muslim scholars which has yet
to be widely practised by Islamic banks is the issuance of an
"asset-based itiiidharabah” instrument in place of debenture bonds.
This instrument represents monetary claim against funds under the
management of the Islamic bank on a fiduciary basis. The operations
 ISLAMIC FINANCIAL MAKKI IS 369

and arrangements of this instrument are similar to mutual funds or

unit trust. There are two types of mudharabah instruments suggested,
namely unrestricted mudharabah and restricted mudharabah. Under
unrestricted mudharabah, the Islamic bank acts as the mudarib and is
authorized to use full discretion in managing the affairs of the funds.
The restricted mudharabah, on the other hand, has specifications as
to the period, place, purpose and type of business allowed. The
bank is only allowed to perform functions that are prescribed in
the prospectus or mudharabah agreement. The following are the
suggested features of a mudharabah bond (Pervez, 1996):

(i) Asset valuation is undertaken at the end of each prescribed year.

A positive price movement over the previous asset-valuation
date reflects return on investment which is declared on each
asset valuation date. Net profit after payment of all mudharabah
costs is distributed between the instrument holders and the
bank. The bank's management fee is a fixed percentage of the
profit as agreed in the contract. The bank may, however, on its
sole discretion reduce but not enhance its fee by voluntarily
forgoing part thereof.

(ii) Ln the event of a net loss, the net asset value is reduced and the
bank cannot impose managemant fee for the period. If the loss
is as a result of gross negligence or violation of the terms of the
contract, then the bank has the responsibility to compensate
for the loss.

(iii) The creditors do not have any recourse to other assets of the
instruments holders should their claims exceed the total assets
of the mudharabah.

(iv) Although the bank's management fee based on a fixed

percentage of net profit is permittted, imposing a fixed amount
of payment is not.

(v) In line with the contract, reserves, as a percentage of net profits,

can be built to meet future contingencies and unforeseen losses.
370 CHATTUt 7

At maturity of the contract, the amount held in reserves after

meeting all costs and claims is distributed to holders of the
bond.
Jordan is among the earliest countries to introduce asset-based
mudharabah bonds. Asstipulated in Late No. 13ofl978. Jordan Islamic
Bank is allowed to issue financial instruments called muqaradah
bond. This Law defines the bond as follows:

Documents having a uniform value, issued by the bank in the names

of the persons who subscribe thereof by paying their face value on
the basis of participation by the holders of these bonds in the animal
profits realized, in accordance with the terms of each separate issue of
such bonds.
Based on the above interpretation, the most important element of
the nmqaradali bond is that its issuance and returns to the holders
are based on the profit-sharing principle. Although Jordan Islamic
Bank was allowed to issue such bonds, the instruments were issued
by the bank only in 1997. Instead, it was first undertaken by the
Jordanian government, though on a limited scale. The enactment of
the Muqaradah Bond Act 1981 by the Jordanian government paved
tlie way for the Ministry of Awqaf to develop wakaf assets. Among
the authorities which have been allowed to issue bonds under this
Act are the Ministry of Awqaf, public institutions with financial
independence and municipalities. One important aspect related
to the issuance of muqaradah bonds provided by law is that the
Jordanian government guarantees the settlement of the face value
of the bonds. This guarantee is in line with the fatwa issued by
the Jordanian Fatwa Committee that government's guarantee (the
government as the third party I is permissible and does not contradict
Syariah. At the end of 2007, the muqaradah bonds were valued at
JOD218.5 million whilst at the end of 2006 it was JOD166.7 million
(Jordan Islamic Bank. 2007). The issuance process depends mainly
on which projects the bank regards as economically potential.
After identifying the financial needs of a project which it intends
 ISLAMIC FINANCIAL MAK KI IS 371

to venture into, Jordan Islamic Bank would offer the bonds to the
public by allowing them to purchase the bonds based on a fixed
face value. Annual profit would only be distributed based on the
profit obtained from the project and the principal money would be
returned upon its completion.
Apart from Jordan, Pakistan was also interested in issuing
Syariah-based bonds when it converted its whole economic
system to an Islamic system in 1977. For that purpose, two new
laws were formulated, called Modaraba Companies and Modaraba
(Flotation and Control) 1980 and Modaraba Companies and Modaraba
Rules 1981, The aim of these laws is to provide the necessary
framework for the flotation of mudaraba instruments and permit
management companies, banks and other financial institutions to
register themselves as mudaraba companies and to enable them to
issue financial instruments of this type in Pakistan. This financial
instrument bears similarities to muyaradah bonds issued in Jordan,
that is, bonds with restrictions and without restrictions. An
additional feature of the bonds in Pakistan is that they can either
be for a limited period or for perpetuity. These Islamic bonds are
traded on the Karachi Stock .Market. Besides mudharabah bonds,
another type of Islamic financial instrument recommended by the
Council of Islamic Ideology, Pakistan, is the Participation Term
Certificates (PTCs). The following are the salient features of PTCs
(Qureshi, 1990):

1. PTCs are for a specified period not exceeding ten years excluding
the grace period.

2. The broad principles governing the legal aspects of PTCs are

laid down by the government by making suitable amendments
in the prevailing Company Act.

3. As the PTC finance is provided for a specific period, it is

secured by a legal mortgage on fixed assets of the company and
a floating charge on the current assets owned by the company.
372 CU APTI K 7

4. For the purpose of profit allocation to PTC holders, the

investment ranks pari-passu with equity. Profit sharing is based
on mutual agreement.
5. Pre-tax profits before appropriations are used in determining
return to the PTC holders.

6. Profits payable to the PTC holders are income tax-deductible

expenses.

7. Tlie share of profits paid to PTC holders is deducted prior to

shareholders' claim on the company's profits.

8. In the event of a loss, the first recourse shall be to free the reserves
including the credit balance in the profit and loss accounts of
the issuer and the balance of the loss will be shared between the
PTC holders and other providers of funds in proportion to their
funds.

9. Proceeds of the PTC must be used exclusively for implementing

the project as stated when the PTC was issued to potential
investors. PTC issuers must conduct the business with diligence
and efficiency and to use all expertise and wisdom when
operating the business ventured into.

10. For purpose of providing protection to the PTC holders, a

trustee must be appointed and given the authority to obtain
information from the company, to visit the plant and to inspect
machinery of the company as well as to have access to all their
business records.

11. Options may be given to PTC holders to convert a certain

portion of their outstanding certificates to ordinary shares.

12. A rights option may also be given to ordinary shareholders to

subscribe to any new issuance of PTCs.

From the above features, one can see many similarities between PTCs
and conventional bonds. For instance, PTCsare secured by mortgage
 ISLAMIC FINANC IAI. MAKKI LS 373

and floating charges and this feature is similar to mortgage bonds.

Furthermore, the option for the holders toconvert their certificates to
common or ordinary shares is a feature of subordinate debentures.
Although this instrument is acceptable in Pakistan, some Muslim
scholars are doubtful as to the permissibility of it (Ariff and Mannan,
1990). This is because its legality from the Syariah viewpoint has
yet to be established. Nevertheless, PTCs and mudharabah bonds
have been issued in Pakistan although they have not been well
received. For example, the face value (nominal) of investments in
securities undertaken by banks in Pakistan at the end of 2008 was
PKRl,000,357.2 million and of this amount, investment in PTCs
was only PKR35.175.1 million or 3.5% of the overall investment.
Meanwhile, investment in mudharabah bonds was PKR30.265.8
million or 3% of total investment. Islamic bonds or more commonly
known as sukuk, which are based on the mudharabah concept have
not been fully developed by other Islamic countries and banks alike
throughout the world. Islamic Development Bank, despite being
the pillar of financial management based on Syariah, has not been in
the forefront in issuing sukuk mudharabah. The bank, however, has
introduced two asset-based mudharabah instrument schemes known
as Islamic Banks' Portfolio (IBP) and Unit Investment Fund (UIF).
IBP is a pool of funds contributed by institutions and individual
investors for the purpose of financing trade, undertaking leasing
and for equity' participation in corporations of Islamic countries.
UIF, on the other hand, is largely used to finance leasing assets and
for instalment sales. Since their establishment and until 2006, IBP
valued at US$4.4 billion and UIF at US$1.8 billion were managed
by Islamic Development Bank
This situation does not mean that no other efforts have been
taken to develop Islamic bonds, Malaysia, for instance, is quite
advanced in developing Islamic bonds. Islamic bonds are issued
by both the government and private sector. Since the issuance
of Islamic bonds based on musyarakah by Shell MDS Sdn Bhd in
1990, their popularity has been on the rise from year to year. In
374 CHAPTER 7

2(X)1, the issuance of Islamic bonds in Malaysia surpassed that of

conventional bonds. As at end of June 2008, the Malaysian bond
market reached a size of more than RM500 billion with corporate
bonds representing 51% or RM258 billion of total outstanding
bonds. Throughout 2008, a total of 44 Islamic bonds or sukuk with
an issuance value of RM3.234 million were approved by Securities
Commission of Malaysia (www.sc.com.my).
Besides Malaysia, Bahrain also plays an important role in the
issuance of Islamic bonds. Islamic bonds issued in Bahrain are
based on the principles of salam and ijarah. The history of Islamic
bonds in Bahrain started in 2001 when salam sukuk was first issued.
This monthly issuance valued at US$25 million each was offered for
sale by Bahrain Monetary Agency (BMA). As at end of November
2008, BMA had administered new issuance of salam sukuk worth
BD6 billion. Apart from salam sukuk, BMA also issues ijarah sukuk.
The first ijarah sukuk was issued in September 2001 with a value of
US$100 million and a maturity of five years. In addition, on 20 July
2004, BMA issued ijarah sukuk in Bahraini currency (dinar or BD)
totalling BIMO million (US$106 million) with a maturity of ten years
Up until November 2008, new issuances of ijarah sukuk totalling
BD5 billion were issued and traded on the Bahrain Stock Market.
The presence of the Islamic International Finance Market (IIFM)
is also expected to act as impetus for the issuance of Islamic bonds
worldwide. As an international body which among its major tasks
is to endorse the issuance of Islamic bonds and ensure they are
indeed Syirn'ali-complianl. the service of HI M is highly required by
companies intending to issue Islamic bonds and would like their
bonds to be subscribed by the international community. As at the
end of July 2008, IIFM had endorsed six issuances of Islamic bonds
as follows (http://www.iifm.net):

(i) US$600 million - Malaysia Global Sukuk

(ii) US$400 million - Solidarity Trust Services Limited Trust

Certificates
 ISLAMIC FINANCIAL MARKLTS 375

(iii) US$700 million - Qatar Global Sukuk

(iv) US$250 million - Bahrain Monetary Agency International

Sukuk ,

(v) US$100 million - Tabreed Finance Corporation Trust

Certificates

(vi) US$120 million - Durrat Al-Bahrain Sukuk Company B.S.C.

Currently, principles such as ijarali, istisna, salam, murabahah and

bai bithaman ajil are used widely in structuring Islamic bonds.
However, there is a lack of consensus among the ulama as to the
fact that the discounting method implemented in transactions in
the bond secondary market is Si/itn«/i-compliant. For instance, the
principle of bai al-dayn which is widely used in Malaysia is strongly
opposed by the ulama in the Middle East on the basis that only debt
certificates of the same value may be transacted.

Money Market
The most important function of the money market is to provide an
efficient means for economic units in the economy to adjust their
liquidity positions. Financial instruments in this market have three
crucial features, namely low default risk, short term to maturity
and high marketability. In the conventional money market, the most
widely traded financial instruments are treasury bills, negotiable
certificates of deposits, bankers acceptance and repurchase
agreements.
Treasury bills are bills issued by the treasury department of a
country. The proceeds of these bills are used to finance government
operating expenditures. The billsare sold to investors on adisounted
basis (lower than face value). The income obtained by investors is
the difference between the face value and the purchase price of
the bills. Treasury bills are issued with maturities of three months,
376 ciiArttK*

six months, nine months and one year. Negotiable certificates

of deposits are another type of time deposit facilities offered
by financial institutions, particularly commercial banks, with a
minimum amount of savings for each certificate (e.g. RM50,000).
The certificate usually has a maturity' period of not more than one
year, and the interest rate offered by the bank is pre-determined at
the initial stage of the savings period. The certificate is then resold at
any time, whether at the issuing bank or at the secondary market.
Banker’s acceptance arises most often in connection with
international trade and is commonly issued to facilitate import­
export transactions. It is known as a bill of exchange drawn on and
accepted by banks. Upon acceptance, that is, when the banker's
acceptance is endorsed by the bank, the bank assumes responsibility’
for ultimate payment to the holder of the draft. With this, the financial
instrument becomes negotiable and can be traded on the secondary
market. Banker’s acceptance transactions are implemented based
on the discounting method, where purchase is made at a value
which is lower than the value of the certificate on maturity. On the
maturity date, the bank pays the holder of the banker’s acceptance
the face value of the certificate. A repurchase agreement is normally
issued by the banks and other financial institutions such as discount
houses and merchant banks. This agreement consists of the sale of a
short-term security by the bank to investors in return for cash, and
pledges to repurchase the instrument from the investor at some
later date at a pre-determined price which constitutes the face value
plus interest payment. The agreement gives tire buyer the right to
retain interest earnings based on the period of execution of the
repurchase.
Financial instruments for the Islamic money market have not
really expanded to Muslim countries Nevertheless, Malaysia,
followed suit by Indonesia, have started to pave the way by
providing Syariiih-based financial instruments for negotiation in the
money market. In 1994. Malaysia established an Islamic inter-bank
money market which consisted of three chief components, namely
 ISLAMIC FINANCIAL MARKETS 377

inter-bank trading in Islamic financial instruments, Islamic

inter-bank investments and inter-bank cheque clearance system.
However, in 1999 when consolidation occurred in the cheque
clearance system, RENTAS (Real Time Electronic Transfer of
Funds and Securities), the Islamic inter-bank cheque clearance
system ceased to be regarded as a component of the Islamic
inter-bank money market. Currently, the Islamic inter-bank money
market is made up of two components only, namely inter-bank
trading of Islamic financial instruments and mudharabah inter-bank
investments.
Inter-bank trading is a market where banks would trade among
one another all the Syariflh-based financial instruments. These
financial instruments comprise Government Investment Issue
(G1I), Bank Negara Negotiable Notes (BNNN), Islamic Accepted
Bills (1AB) and Islamic Negotiable Instruments (INI). Financial
instruments of this type were introduced as a mechanism whereby
the deficit bank (investee) obtains investment from a surplus bank
(investor bank) based on mudharabah. The period of investment is
normally from overnight to 12 months. The rate of return is usually
based on the rate of gross profit before distribution for investments
of one year. At the time of the negotiation, the investor bank will
not know the amount of return it will receive; it will only know at
the end of the investment period. On 2 February 1996. Bank Negara
introduced a minimum benchmark rate for these investment
certificates which is based on the prevailing rate of the Government
Investment Issues plus a spread of 0.5%. The purpose of imposing
this benchmark rate is to ensure that only banks with reasonable
rates of return may participate in the Islamic money market.
Besides the financial instruments mentioned above, Bank Negara
also provides Islamic inter-bank deposit facilities based on the
wadiah principle. This facility is intended to serve as a method to
absorb any surplus liquidity in the Islamic banking system. Apart
from Malaysia, Indonesia has also taken similar steps in providing
financial instruments for the Islamic money market system and
378 chapter 7

making available inter-bank deposit based on the wadiah principle

and inter-bank investment certificates based on the mudharabah
principle,

Forward and Future Markets

The goal of the forward market and future market is to enable
participants in the markets to offset their price risk in future
transactions which involve money, security or commodity. The seller
and buyer in both markets are allowed to establish their terms of
the exchange prior to future delivery date. Unlike forward market
in which contracts between seller and buyer are not standardized,
contracts in the future market are. Additionally, future contracts are
made between parties involved in the transactions and the futures
exchange, and not with each other.
Forward market is allowed by Syariah, as supported by the
fact that there are a number of Syariah principles which are of
relevance to forward transactions, namely salam. istijrar and istisiia
(also known as bai salam, bai istijrar and bai istisna, respectively).
However, there is divergence of opinion regarding the types of
goods that may be transacted in the forward market. For instance,
Islamic banks in Jordan. Egypt and Sudan are prohibited from
engaging in forward currency trading. Currency trading can only
be executed at spot rate (sometimes called immediate rate or other
rates), whereas both spot and forward transactions are available at
Islamic banks in other countries. Futures market, meanwhile, is the
least developed component of the Islamic capital market because
it is very much at a controversial stage. The legitimacy of future
market is inconclusive among Muslim scholars. Some scholars have
asserted that futures market is not permissible because it involves
the sale of goods not in possession of the goods. Others have strong
opposite opinions on the matter. Kamali (1997), a modern scholar,
was of the opinion that futures contracts may be allowable because
 ISLAMIC FINANCIAL MARKETS 379

it does not involve gambling, riba and uncertainties. In fact, there is

no clear prohibition in the Quran and Hadith against futures sales.
However, ElGari (1998) questioned the usability of this financial
instrument. He believed that if the salam principle was applied
on future sale transactions, then payment should be made at the
time the contract was signed and not in the future. Nevertheless,
the Syariah Advisory Council of the Securities Commission of
Malaysia, at its lithe meeting on 26 November 1997, resolved that
the futures contract involving crude palm oil was allowable and in
accordance with Syariah.
With forward markets for commodities allowed by Syariah,
there is a high possibility for the securitization of debts that
emerge from these transactions. In fact some Muslim countries
have already created bills to be traded in the capital market and
money market based on forward trading. For example, banker's
acceptance is a financial instrument created based on forward
trading. However, there is divergence of opinion pertaining to the
legitimacy of debt securitization that derives from such instrument.
In Malaysia, transactions based on the bai ad-dayn concept is widely
enforced, but this concept is rejected by scholars in the Middle
East. Consequently, this has limited the use of this instrument and
questioned its applicability in the market.
The most widely traded financial derivatives in the forward
and future markets as well as the capital market of the conventional
system are warrants and options. Warrants are a type of security
which gives its holder the right to buy common stocks directly
from a company at a potentially advantageous price. This right is
usually issued in combination with long-term debts such as bonds
or debentures. Options, on the other hand, allow the holder to enter
into contracts to buy or sell shares, commodities or currencies at
a pre-determined price called the strike price until some future
date. There are two types of options, namely call option and put
option. In a call option, the holder is given the right to buy, while a
put option gives the holder the right to sell a security or a futures
380 CHAFTIK 7

contract at a strike price. The company, on the other hand, has the
responsibility' to sell or buy the options at the pre-determined price.
However, the holder of the warrants and options may at any time
sell his right on the stock exchange or any secondary market at a
market determined price.
There is considerable debate among Muslim scholars about the
legality of warrants and options which has yet to be resolved by
Syariah. Syariah permits the use of options. For instance, in the case
of murabahah and ijarah, options are sometimes given to the buyer
or tenant in the event that the goods contract defaults. EIGari (2004)
was of the opinion that call option is lawful and is called arboon.
This view is supported by Kamali (2002). In Malaysia, warrants and
options are permitted so long as they originate from shares which
are allowed by Syariah. The legitimacy of warrants and options lies
in the fact that the holder is entitled to exercise his right just as the
owner of a property has the right to dispose of his property in the
open market. In this case, warrants and options are regarded as mal
and the owner of the mal may resell it.

Mortgage Market
Mortgage market refers to the market that provides finance for
real estate. Real estate loans are normally issued by various tvpes
of financial institutions. Commercial banks, savings and loan
institutions and cooperatives are institutions in the forefront in
providing this type of property loan. Interest-based loans impose
various terms and conditions including matters related to interest
rate and method of repayment. Repayment varies and depends to
a large extent on the lending institution. Some institutions charge
fixed monthly instalments until maturity, while others charge
either a small initial instalment with progressive payment until full
repayment is made or repayment based on the amount of interest
incurred. There are also Ioans which require the borrower to settle
 ISLAMIC FINANCIAL MARKETS 381

all interest incurred but pay instalment on the principal and interest
at some future date.
As with conventional banks, Islamic banks adopt various
methods with respect to matters related to real estate financing.
Repayment depends on the Syariali principle applied by each
bank. For instance, an Islamic bank buys a property at the original
price and sells it to its customer at a higher price. The customer is
required to pay a certain portion of the profit the bank earned from
the higher sale price before paying the original purchase price of
the property. Some banks require that the customer pay the profit
together with the original cost of the real estate during the initial
stage of financing. Others adopt a repayment method whereby the
customer makes small initial payments followed subsequently by
higher repayments towards the end of the financing period. The
amount of instalment depends largely on the agreement between
the bank and its clients. Although Islamic banks do not face any
real issues or problems in providing such real estate financing, the
securitization concept must be in placed or established so that it
does not become immobilized.
In the conventional system, there are two types of mortgage-
backed securities instruments, namely pass-through mortgage
securities and mortgage-backed bonds. Pass-through mortgage
securities refer to securities that "pass through" all payments of
principal and interest on pools of mortgages to holders of security
in the pool. For example, let us assume a financial institution has
a real estate loan of RM100 million (inclusive of principal and
interest) for which a RM 100 million bond is issued against this
property. Thus, when the borrower pays for the loan plus interest,
the financial institution would immediately channel that payment
to the bondholder based on the value of the bond held. For instance,
if a person holds 1% of the bond value, he is entitled to receive
1% of the total principal and interest payment. Mortgage-backed
bonds are similar to corporate bonds which have a fixed maturity
date and interest payment except that these bonds have specific
382 CHATTER 7

mortgages as collateral. The bondholders would receive interest

payment on the due date and principal payment upon maturity.
Collaterals on these bonds are the real estate loans issued by the
financial institution to the real estate owners.
Islamic mortgage market is still undeveloped. Currently,
no Islamic financial institution has used real estate financing in
sukuk issuance. However, Malaysia has taken precedence over
the development of Islamic mortgage market. The use of Islamic
mortgage bonds is administered through the National Mortgage
Corporation or Syarikat Cagamas Berhad (Cagamas), a subsidiary
company of Bank Negara Malaysia. Cagamas was established
in 1986 with the objective of financing the purchase of housing
loans and other consumer receivables from financial institutions
and issuing bonds to purchase the loans. These Cagamas bonds
would then become the main driver of growth and catalyst for
the development of a secondary mortgage market. There are four
types of bonds issued by Cagamas: (i) Fixed Rate Bonds which have
tenures of one and a half years to seven years with semi-annual
interest payments; (ii) Floating Rate Bonds which have tenures
of up to seven years and an adjustable interest rate pegged to the
Kuala Lumpur Inter-bank Offer Rates (KLIBOR); (iii) Short-term
Notes which have maturities between 1 month to 12 months and
only pay the face value at maturity; and (iv) Sanadat Mudharabah
Caganias which are Islamic bonds based on the profit-sharing
principle. Bondholders receive dividends semi-annually based on
a pre-determined profit-loss ratio.
Funds collected through the issuance of conventional financial
instruments are used to purchase housing loans. The Sanadat
Mudharabah Cagamas are used to purchase Islamic home financing
debts. Since 2001, Cagamas has also started to acquire Islamic
hire purchase debts. Although Cagamas purchases Islamic home
financing debts and Islamic hire purchase debts from financial
institutions, the acquisition made is purchase with recourse. This
means that when the bank sells the debts to Cagamas, it agrees to
 ISLAMIC HNANCIAI MARKETS 383

reimburse Cagamas for losses resulting from the purchased loans

such as replacing any bad debts. Cagamas has also set several
conditions in its debt purchase transactions. As at the end of 2007,
total Islamic home financing debts purchased by Cagamas was
RM12.6 million, while Islamic leasing debts purchased amounted
to RN13.408.6 million (www.cagamas.com.my).
Although Cagamas, in principle, has paved the way for the
implementation of the securitization process for Islamic home
financing debt and Islamic hire purchase debt, this process could
be developed further by allowing Islamic financial institutions
to issue their own bonds. Apart from financial institutions, other
organizations could also be authorized to manage the issuance and
trading process of these Islamic mortgage bonds. Syariah principles
such as wakalah could possibly be used to implement and develop
the Islamic mortgage market.

Unit Trust Market

The unit trust market is another branch of the financial market
which can be explored and operated more actively in accordance
with Syariah. Unit trust funds are essentially collective investment
schemes structured to allow investors with similar investment
objectives and risk tolerance to pool their savings in a common
fund. Tire pool will then be managed by an investment company
and invested in a diversified portfolio of authorized investment on
behalf of the investors in accordance with the investment objectives
of the trust funds. The investment scheme of the unit trust fund
involves a tripartite relationship between the fund manager, trustee
and investor who are legally bound by the terms and conditions
specified in the Trust Deed. The fund managers are professionals
who are highly skilled in investment and are responsible for the
management and operations of the unit trust funds. The pooled
funds are invested in any or a combination of investments such as
384 CHATTER 7

shares, money market instruments, futures contracts, commodities,

bonds, private debt securities and others. If the accumulated funds
are invested mainly in shares traded on the stock exchange, then
the funds are known as equity funds. Assets of the trust funds are
owned by the trustee, not the fund manager. Investors normally
do not have any rights on the assets purchased by the managers;
instead their investment returns are in proportion to the numbers
of units owned.
The method of fund mobilization based on the unit trust
scheme first started in the United Kingdom in 1931. In Malaysia, a
unit trust was first established by a company called Malayan Unit
Trusts Limited in August 1959. In 1963, this company was bought
over by the South-East Asia Development Corporation which had
two subsidiaries, namely Singapore Unit Trusts Limited which
operated in Singapore and Asia Unit Trusts Berhad which had
operations in Malaysia (Bank Negara Malaysia, 1984). The industry
was initially regulated by Bank Negara Malaysia but since 1993, the
principle legislative body governing the establishment, operation
and administration of unit trust is the Securities Commission of
Malaysia. The governing legislatures for the unit trust industry are
the Trusts Act 1949 and the Companies Act 1965.
There are two types of unit trusts, open-ended and closed-
ended unit trusts. With an open-ended fund, there is no fixed pool
of money. The total amount of money available for investment and
the number of units in existence increase or decrease depending
on the subscription and redemption of units in the fund. Investors
of the unit trust may at any time redeem on demand their units at
market price, either directly from the manager or through appointed
agents. Closed-ended fund, on the other hand, has a fixed size and
are incorporated companies whose businesses are to buy and sell
shares on the stock exchange. No new shares are issued after the
subscription period ends. Closed-ended fund shares are listed
and traded through the stock exchange and prices of these shares
are determined by market forces. Investors normally receive two
 ISLAMIC FINANCIAL MARKETS 385

types of returns, namely capital profit from the price increase of the
unit trust, and annual dividends, if any, obtained at the end of the
financial term.
The development of the unit tnfst industry in Malaysia gained
momentum and unit trusts became a household product with the
establishment of Perbadanan Nasional Berhad which manages the
Amanah Saham Nasional scheme in April 1981. A variety of unit
trust schemes were launched by this corporation and subsequently
by other finance corporations. As at 31 December 2008, there were
39 corporations managing unit trust schemes. The total funds
approved were 521 and the approved fund size was 473.939 billion
units, while units in circulation were 208.342 billion. The total
account for the trust units was 12,274,908, with the asset value of
funds totalling RM169.414 billion (www.sc.com.my).
Since managing unit trust does not involve any elements of riba.
it is therefore relatively easy to put into operation a trust scheme
that complies with Syariah principles. Currently, a great number
of fund management companies are involved in managing trust
funds. These companies are not only operating actively in Muslim
countries but also in Western countries such as the United States
and the United Kingdom. In Malaysia, the successful launch of two
unit trust funds in 1993 by Arab Malaysia Unit Trust Berhad created
the impetus for other fund management companies to follow suit.
This is evidence by the increasing number of Syanu/i-compliant unit
trust funds available today. For instance, all the unit trusts managed
by Perbadanan Nasional Berhad conform to Syariah.
When a Syariii/i-compliant unit trust scheme is launched, a
number of conditions must be complied with. Among them, the
investment undertaken must be in companies that are not involved
in activities which encompass the elements of riba, maisir and gharar.
The companies must not also be involved in the supply, manufacture
or service of things prohibited by Islam such as alcohol, gambling
and non-halal food products. A Syariah Monitoring Board must be
established to monitor and endorse that the investment undertaken
386 CIIATTCK 7

does not involve Islamic prohibitions. A process of cleansing or

purification shall be carried out on the returns of the Islamic unit
trust should any part of it raises doubts.
As at 31 December 2008, there were not less than 149 Syariah-
compliant funds in Malaysia which represented more than 25% of
the total unit trust funds. Two models which may be applied in
managing Islamic unit trust funds are mudharabah and wakalah. If
the mudharabah model is applied, the fund manager would act as
the mudarib and profits obtained from the investment would be
shared with the investor. On the other hand, if the wakalah principle
is used, the manager would only act as a representative and would
receive administrative fees for his efforts. The type of principle used
is normally stated in the prospectus. Under normal conditions, the
contents of the Syarifl/i-compliant fund prospectus are not much
different from that of the conventional fund prospectus. This
is because conditions imposed by the Securities Commission of
Malaysia for both Islamic and conventional trust funds are fairly
analogous except for statements with respect to managing of the
funds, appointment of the Syariah Monitoring Board members and
profit distribution method.

ISLAMIC FINANCIAL MARKET PRACTICES

IN MALAYSIA

The practices of Islamic financial market largely depend on the

financial instruments available. However, the scope of discussion
in this section is limited to the practices of the issuance and trading
of the main financial instruments in the Malaysian financial market.
One important aspect of the financial market that needs a great deal
of attention is the supervision and regulation of each component of
the financial market. For instance, in Malaysia, the entire financial
market was initially under the supervision of Bank Negara
 ISLAMIC FINANCIAL MARKETS 387

Malaysia. However, when the Securities Commission of Malaysia

was established on I March 1993, the supervisory and regulatory
role was transferred to the Securities Commission of Malaysia.
Financial instruments are limited to particular groups only.
Normally, individual and retail clients do not have the opportunity
to use these financial instruments to meet their financing needs
due to the requirements imposed for using such facilities. The
requirements or conditions imposed in turn depend largely on the
financial market regulator. For instance, the issuance of financial
instruments in the capital market necessitates the fulfilment of
certain preconditions set by the Securities Commission of Malaysia
which may be viewed on its website, www.sc.com.my. This section
will discuss major Islamic financial instruments which are actively
traded on the market. Among the financial instruments which will
be discussed are:

a. Government Investment Issue

b. Bank Negara Negotiable Note

c Short-term Trade Bill

d. Islamic Negotiable Deposit Instrument

e. Mudharabah Inter-bank Investment

f. Bonds based on bai bithaman ajil and murabahah principles

g. Bonds without coupon value

h. Bonds based on the ijarah principle

i. Bonds based on Cagamas mudharabah

Government Investment Issue

Government Investment Issue (G1I) is a long-term non-interest
bearing government security issued by the Malaysian government
388 CHAPTtK 7

to fund the government's development expenditure. It is also

one of the most actively traded Islamic financial instruments on
the secondary market. The Gil was first issued in 1983 bv the
government to enable Bank Islam .Malaysia to channel its surplus
fund to an income-generating investment. This initial issuance was
based on the qard hassan principle, where investors would provide
interest-free loans to the government and at maturity the investors
would receive hibah or gift from the government based on certain
percentages. However, Gil was not a tradeable instrument as qard
hassan principle did not permit trading on the secondary market.
In order to allow the instrument to be traded on the secondary
market, the underlying concept was changed to bai al-inah principle,
from June 2001. Under this principle. Bank Negara .Malaysia on
behalf of the government will sell government-owned assets and
subsequently buy back the assets at its nominal value plus profit
through a tender process. The nominal value will be settled at
maturity while the profit rate will be distributed semi-annually
Profit rate is based on the weighted average yield of the successful
bids of the auction.
The task of issuing GII is given to Bank Negara Malaysia through
its Department of Investment Operations and Financial Market. At
certain times Bank Negara Malaysia will invite financial institutions
to subscribe to GII. Each certificate is valued at RM I million while the
minimum purchase amount is also RM 1 million. The purchase of this
financial instrument is limited to members of the financial market,
namely commercial banks with Islamic banking branches, Islamic
banks, merchant banks and discount houses. Transaction of this
financial instrument is based on scriptless trading, where the sale and
purchase is recorded by the Department of Investment Operations
and Financial Market. When purchasing GII, financial institutions
are also required to make other payments such as commission and
stamp duty. Similarly, when GII matures, Bank Negara Malaysia
would pay the holders the agreed price. This instrument is normally
traded on the secondary market using the bai al-dayn principle. The
 ISLAMIC FINANCIAL MARKETS 389

selling price is usually pre-determined by the seller as well as the

buyer. In March 2005. the Malaysian Government issued the first
profit-based Gil worth RM2 billion. This five-year coupon-bearing
paper pays half-yearly profit to investors. A significant development
was achieved on 17 June 2005 when the Government Funding Act
1983 (previously known as the Government Investment Act 1983) was
amended whereby the issuance limit of the Gil was increased from
RM15 billion to RM30 billion. The outstanding amount of Gil issued
as at 18 February 2008 was RM46 billion. The issuance of Gil was
RM18 billion and RM10 billion in 2008 and 2007, respectively.

Bank Negara Negotiable Note

Bank Negara Negotiable Note (BNNN) is a short-term Islamic
financial instrument issued by Bank Negara Malaysia to financial
institutions involved in the money market. These notes are a type
of deposit notes based on the bai al-inah principle. Bank Negara
Malaysia would offer its assets (usually in the form of a collection of
shares listed on Bursa Malaysia) to be purchased by way of tender
by financial institutions that have been listed by the central bank
as members of the financial market. At the same time, the central
bank agrees to repurchase the notes at RM1 million per note. This
financial instrument was first issued by the central bank in 1999.
The timing and amount of negotiable notes to be issued depend
on the central bank. Institutions that wish to subscribe to the notes
are required to submit their respective tenders to the Department of
Investment Operations and Financial Market before the closing date.
As with Government Investment Issue, the issuance of these notes
is also based on scriptless transaction. For this type of notes only
sales information such as the name of the buyer and total amount
of purchase, needs to be registered. The buyers would then pay in
cash the agreed tender price to the central bank. These notes are
tradable on the secondary market based on the hoi ai-dayn principle.
390 CHArtFK 7

The potential seller would make an announcement of his intention

at the secondary market, and the sales value depends on factors
such as the time span involved in the transaction and the maturity
period of the notes. At the end of the maturity period, the central
bank would pay holders the face value of the notes. Bank Negara
Negotiable Notes issued for 2001, 2002 and 2003 were RM1 billion,
RM2 billion and RM1 billion, respectively- The outstanding
amount as at the end of 2003 was RM3 billion. In 2001, 2002 and
2003. the notes traded on the money market totalled RM1.2 billion,
RM2.2 billion and RM8.8 billion, respectively. In order to further
spur the trading activities of the notes, financial institutions that
are appointed as principal dealers are allowed to list the sale or
purchase price. Market participants may conduct their business
transactions based on the price offered by the principal dealers.
In 2006, the BNNN was replaced by Bank Negara Monetary
Note (BNMN) pursuant to the amendments of the Central Bank of
Malaysia Act 1958. As such, all maturing issues of BNNN will be
replaced with BNMN on a gradual basis. The maximum maturity
of BNMN has been lengthened from one to three years and may
be issued either on a discounted or coupon-bearing basis. As at
18 February 2008, the outstanding amount of BNMN in the markets
stood at RM500 million.

Short-term Trade Bill

Islamic short-term trade bill was first introduced in Malaysia in

1992. This financial instrument is similar to banker's acceptance in
the conventional banking system and is based on the concept of
intirabaltah and bai al-iiayn. These bills are another money market
instrument aimed at encouraging and promoting both foreign and
domestic trade by providing traders with an attractive Islamic
financial products for either purchase or sale purposes. However,
these short-term trade bills can be drawn to finance domestic
 ISLAMIC FINANCIAL MARKETS 391

purchases or imports and domestic sales or exports of goods or

items that are not prohibited in Islam.
For imports or domestic purchases, financing provided by the
Islamic bank is based on the inurabaKali principle. Under thisconcept,
the bank appoints the customer as the purchasing agent who then
purchases the required goods from the seller on behalf of the bank.
The bank pays the seller for the goods and then resell them to the
customer on deferred payment of up to 200 days. Upon maturity,
the customer shall pay the cost of goods plus profit margin as
agreed by both parties. The bill represents the customer's promise
to pay the bank the rate stipulated in the bill upon maturity- If the
bank is willing to accept the responsibility as the recipient of the
bill, then the result would be what is termed Islamic Accepted Bills.
If the bank decides to sell the bill to a third part}', then the concept
of bai al-dayn or debt sale will apply. Normally, the sales are based
on the discounted bai al-dayn method. At maturity, if the bill has
been sold to a third party, the bank which accepts the responsibility
(or the bank which undertakes to endorse acceptance) will make
payment to the legal bill holders. At the same time, the client will
issue payment to the bank to fulfil his responsibility as stated in the
bill. The seller or exporter will prepare export documents under the
sale contract or letter of credit. The documents are then presented
to the bank for purchase. The seller will then draw another bill of
exchange on the bank. This mode of financing enables the seller to
obtain instant cash for managing his working capital by selling the
debt to the bank.
This sale transaction involves a securitization process, whereby
the bank purchases the customer's right to the debt, which is
normally securitized in the form of an accepted bill. The sale is
based on the bai al-dayn principle and the bill is sold to the customer
at a discount from the face value. The bill ma}' be traded on the
secondary market and the price of the bill is determined by using
a certain formula, that is, by taking into account the face value,
annual rate of profit and number of days remaining to maturity.
392 CHARTER 7

At maturity, the bank would issue payment to the bill holder and
collect back the payment from the gains of the letters of credit
in the original transaction. These short-term trade bills may also
be redeemed before the end of the maturity period. The amount
required to be paid for this early redemption depends on factors
such as face value, the redemption rate which has been mutually
agreed upon and number of days remaining to maturity The
Islamic Accepted Bill is an actively traded financial instrument on
the secondary market. In 2008, a total of RM7.020 million of these
bills were traded as compared to RM5.183 million in 2007. This is
evidence that Syariah-based short-term trade bills are increasingly
becoming a popular financial instrument among businessmen in
dealing with international business transactions.

Islamic Negotiable Instrument of Deposit

Islamic negotiable instrument of deposit is a type of deposit facility
provided by Islamic banks for their clients. This instrument was
first issued in the year 2000. Bai bithaman ajil is the original principle
used. However, this instrument can also be issued based on the
mudharabah and bai al-inah principles. The minimum amount for
each certificate of deposit is normally RM50,000. These negotiable
certificates of deposit can be traded on the secondare market. The
selling price is usually determined by several factors, namely the face
value of the certificate, maturity period and profit rate given by the
bank if the mudharabah principle is used. The tender method would
be used if the certificates are based on the bai al-inah principle.
The issuance process of this instrument is subject to the approval
of Bank Negara Malaysia. The issuance process is normally executed
by the treasury department of a financial institution, and the branch
only acts as a link between the client and the treasury department
at the headquarters. At maturity, the headquarters would pay the
holder the principal plus return. The clients can sell the instrument
 ISl.AMU FINANCIAL MARKETS 393

before maturity on the secondary market or to the issuing bank.

The use of this type of financial instrument has not reached its
maximum capacity in the money market. A major issuance of this
financial instrument in Malaysia 'was the RM200 million Active
Commodities Islamic Negotiable Instruments of Deposit by
Amlslamic Bank in August 2008.

Mudharabah Inter-bank Investment

The Mudharabah Inter-bank Investment was initiated by Bank
Negara Malaysia in 1994, when the Islamic money market was
first introduced in the Malaysian Islamic banking system. This
instrument is the mechanism whereby the deficit financial institution
can obtain investment from the surplus financial institution on
a mudharabah or profit-sharing basis. Some of the features of this
instrument are as follows:

(i) Investment time span is from overnight to 12 months.

(ii) Minimum amount of each investment is RM50.000.

(iii) Rate of return is based on the rate of gross profit before

distribution for an investment of one year of the investee
bank.

(iv) The profit-sharing ratio is negotiable between both the investor

and investee.

(v) At the time of negotiation, the return is unknown to the

investor bank since the actual return will only be crystallized
at the end of the investment period. (However, Bank Negara
Malaysia maintained that as of February 1996, the minimum
rate of return would be based on the return provided by the
Government Investment Issue plus 0.5%.)

The formula for calculating the profit element to be paid to the

provider of the fund or investor is as follows:
394 CHATTrK 7

Y = PXRXT(K)
36500
Where:
Y • Amount of profit to be paid to the investor
P = Principal investment
R = Rate of profit before distribution for a one-year investment
of the investee bank
T = Total number of days invested
K = Profit-sharing ratio

This instrument is actively traded on the Islamic inter-bank money

market. The total money market transactions under the Mudharabah
Inter-bank Investments was RM256.1 billion in 2006. Throughout
2007 and 2008. a total of RM271 billion and RM224 billion of this
instrument was traded, respectively.

Bonds Based on Bai Bithaman Ajil and Murabahah

Principles
Bonds based on the bai bithanum a/il principle (also commonly known
as BalDS or Bai bithaman a/il Islamic Debt Securities) are among
the early Islamic financial instruments introduced in the capital
market in Malaysia. This method can be used by those requiring
funds to purchase new fixed assets. Among the earliest issuances
by government-owned companies using this method was the
RM2.2 billion issuance by Kl.lA Berhad for financing the construction
of the Kuala Lumpur International Airport in 19% (Osman, 2001).
This issuance was secured by the government of Malaysia. In the
private sector, Houlctn Corporation issued bai bithaman a/il bonds
valued at RM 150 million under two issuances. Ihe first issuance
was on 3 September 1997 and valued at RM120 million with a tenure
of seven years. 'Ihe second issuance worth RM30 million was made
on 3 January 1998 and matured on 2 January 2005. The value of
 ISLAMIC FINANCIAL MAKKLT5 395

bai bithamaii ajil bonds issued in the market was RM1.35O million,
RM820 million and RM2.590 million in 2008, 2007 and 2006,
respectively.
The issuance process and cycle of bonds based on the murabahah
principle (also commonly known as MUNIF or Murabahah
Underwritten Notes Issuance Facility) are quite similar to those of bai
bithaman ajil bonds. The difference between BalDS and MUNIF lies
in their maturity period- The maturity period of murabahah bonds is
shorter, normally not more than five years. Moccis Trading Sdn Bhd
was among the earliest to issue a MUNIF bond. It was valued at
RM50 million and issued on 29 March 1996. This bond had a tenure
of five years. Another issuer of MUNIF bonds was Teledata Sdn Bhd
which issued bonds valued at RM30 million on 5 April 1996. The
bond's maturity date was 4 April 2001. The total issuance value of
MUNIF bonds in the market as at end of 2007 was RM400 million.
The basic process for bond issuance based on the bai bithaman ajil
principle is shown in Figure 7-1.

FIGURE 7-1 Process of Issuance and Cycle of Bai Bithaman Ajil

Bonds
39b CHAPTER 7

Figure 7-1 shows the issuance process of a bai bithaman ajil bond.
The flow is as follows:

1. The applicant (the bond issuer) will discuss and identify the
assets intended to be purchased from the seller of goods and
then sets the conditions for the purchase.

2. The issuer will apply for approval to issue bonds from the
Securities Commission of Malaysia. There are a number of
requirements and conditions which must be fulfilled before
approval can be granted. Bond issuance can only be executed
after approval is obtained.

3. The issuer will discuss with and submit requests to the financier
or investor. Discussion and agreement on the financing

returns to the investor.

4. The financier or investor will undertake the purchase on behalf

of the issuer, and payment will be made according to the agreed
terms between the issuer and the seller of the goods. At times,
the client may be appointed to represent the issuer and purchase
the asset himself.

5. The financier will sell the goods to the issuer on a deferred

payment basis, that is, at the purchase price plus margin of
profit.

6. The issuer evidences the deferred payments by issuing bonds.

These bonds may be based on the principal instalment along
with a profit element, which means that only one type of
certificate or note is issued. Alternatively, the bondholders will
receive two types of payments. If the bondholder desires to take
profit periodically, secondary notes maturing every six months
or every one year will be issued depending on the agreement.
He will receive the principal payment at maturity. The value
of a note or certificate that represents the capital component
 ISLAMIC FINANCIAL MARKITS 397

is called primary note, whereas the profit portion is known as

secondary note.

7. The financier upon receiving the bonds may resell them on the
secondary market based on the bai al-dayn principle.

8. When profit payment to the bondholder is due (e.g. after six

months), the issuer will make profit payments to the holders of
the secondary notes.

9. On maturity, the issuer will fulfil all responsibilities involved

based on the principal value of the bonds.

Bonds Without Coupon Value Based on Murabahah

and Bai al-lnah Principles
In the conventional banking system, bond without coupon value
or zero coupon bond is a type of financial instrument whereby the
issuer pays only the face value of the bond at maturity. This means
the investor buys the zero coupon bonds at a deep discount from
the face value. Normally, the bonds are traded on the secondary
market and the discount price is determined through a bidding
process. This process is allowable in Syarialt and the principle
related to it is called bai inuzai/adali. The Syariah Advisory Council
of the Securities Commission of Malaysia approved the use of this
method at its 10th general meeting in 1997. This mode of financing
is what the country's financial industry needs (Hussain, 1997). The
industry is in dire need of a benchmark for corporate bonds, that is,
a benchmark for the current value of an asset and the profit level.
Khazanah Nasional, a government corporation that manages the
assets of the Malaysian government, was found to be a suitable
institution to issue this Islamic benchmark bond. Consequently, in
September 1997 Khazanah Nasional issued the first Islamic bond,
known as Khazanah Bonds, with a face value of RM1 billion using
398 CHAITtH 7

the murabahah method, and a maturity period of three years. The

outstanding amount of Khazanah Bonds as at 18 February 2009
stood at RM3,350 million. The basic issuance process of this type of
bond is shown in Figure 7-2.

FIGURE 7-2 Issuance Process and Cycle of Murabahah Bonds

Without Coupon Value

Figure 7-2 shows the issuance process of bonds without coupon

value based on the murabahah principle. The steps involved in the
flow are as described below:

1. The issuer will apply for approval to issue bonds from the
Securities Commission of Malaysia. A number of requirements
and conditions must be fulfilled and information provided
before approval can be granted.

2. The issuer will identity the pool of assets to be sold to the

financier. The repurchase value of the asset will be determined
and the payment of the repurchase price will be made by the
issuer on a particular date in the future (bond maturity date).
 ISLAMIC FINANCIAL MARKCTS 399

3. A number of financiers (bidders) will be invited to present

purchase offers on the identified assets, and payment must be
made at the beginning of the duration.

4. The bidder with the best offer price is selected, and the selected
bidder will undertake two agreements with the issuer. The first
agreement involves the cash sale by the bond issuer based on
the purchase price offered by the selected bidder. The second
agreement involves the resale which is based on the murabahah
principle by the financier to the issuer. The selling price
comprises a cost and profit element.

5. The original owner of the asset or the issuer will issue murabahah
notes or bonds to the financier. To enable these notes to be
negotiable on the secondary market, they may be broken up
into several certificates with smaller face values according to
the amount agreed upon.

6. At maturity, the issuer will pay the financier or bondholders the

face value of the bond.

The above process describes the situation where the ‘ai/d resale of
assets is done by the financier for the issuer or the original owner
of the asset. Thus, the principle of this second sale is known as
murabahah, which is a sale involving cost and profit elements. On
the other hand, if the original asset owner executes the sale and
then promises to purchase it at a higher price, then the principle
used is bai al-inah and the bonds involved are known as bonds
without coupon value based on the bai al-inah principle. In this
situation, the two 'aqd involved are, first, sale by the issuer based
on the offer price by the financier, and secondly the pre-determined
repurchase price as agreed upon at the time the offer was made to
the financier.
Bonds based on the baial-inah concept can also be issued through
the normal process which involves only one financier without
administering any tender, or issued based on the bai muzayadah
400 CHAPTER 7

principle. The issuance process for bat al-inah bond is shown in

Figure 7-3. The steps involved are as described below:

1. The issuer will apply to the Securities Commission of Malaysia

for approval to issue bonds. A number of requirements and
conditions must be fulfilled and information provided before
the approval can be granted.

2. The issuer will identify the pool of assets to be sold to the

financier. The sale involves cash payment.

3. At the same time, the issuer will inform the financier about his
willingness to repurchase the asset at an agreed price and the
method of payment. The repurchase price includes the original
price plus the financier's profit. Payment is usually done in
instalments and the resale process is executed by the buyer.

4. As documentary evidence of the arrangement is entered

between the issuer and financier, the issuer will issue bonds to
the financier. The bonds can be issued either by using primary
notes and secondary notes, or simply notes that have both the
elements of cost and profit.

5. The investor may sell the bonds on the secondary market or

hold them to maturity.

6. The issuer will amortize the notes at maturity.

FIGURE 7-3 Process of Issuance and Cycle of Bai al-lnah Bonds

♦
1 6 5

2
Client/Issuer 3 * Financier/Investor

4
 ISLAMIC FINANC1AI StAKKITS 401

Bai al-inah bonds were first used by Bank Negara Malaysia when
the second series of the Malaysia Savings Bond worth
RM377 million was issued. The Merdeka Savings Bond was first
issued in January 2004 by Bank'Negara Malaysia. The April
2008 issuance of three-year Merdeka Savings Bond amounted
to RM2 billion. The bonds will be issued in two series in 2009.
Similarly, the bai al-inah principle was adopted by the profit-based
Government Investment Issue in 2001. Bank Negara Negotiable
Notes are also issued based on this principle.

Bonds Based on the Ijarah Principle

Bonds based on the i/arab principle were among the earliest types of
bonds to be discussed and suggested as a mode of Islamic financing
by Muslim intellectuals. The following are some of the situations
where bonds based on the ijarah principle may be used:

(i) The financier purchases and then leases out the asset required
by the client for a rental fee. The client or lessee makes periodic
rental payment to the financier or lessor. This responsibility
towards the asset owner can be securitized with the rental
payment value based on either monthly, quarterly, semi
annual or yearly payments until the end of the rental period.
The notes or bonds created based on this rental value may be
kept by the asset owner or resold on the secondary market.

(ii) Ijarah bonds may also be issued when the issuer requires
funds for his working capital. In such a situation, the issuer
will identify his assets such as buildings or factories and sell
them to the financier. The financier will buy the assets in cash
and then rent them out to the issuer who shall make periodic
payments as agreed between both parties. Rent payment may
be securitized, where the agreement to pay monthly rentals
402 CHArii’.n7

will be made in the form of notes and submitted to the financier.

These notes or bonds may be kept or resold on tire secondary
market by the financier.

(iii) The third situation involving the ijarah principle is the creation
of a special intermediary body known as special purpose
vehicle (SPV). The SPV will act as the bond issuer and issues
certificates to investors at a pre-determined profit. The SPV
will then enter into an agreement to purchase the assets and
lease them to the lessee. The lessee is obliged to make periodic
rental payment to the SPV which in turn will use these proceeds
to pay the financier.

In Malaysia, the first ijarah bond was issued by Segari Energy

VenturesSdn Bhd on 30September 1997 valued at RM521.5 million.
Repayment to the holder was made four times, RM116 million on
31 March 2002, RM124.5 million on 31 March 2003, RM157 million
on 31 March 2004 and RN1124 million on 31 March 2005. The total
value of ijarah bonds issued in the market was RM6.259 million
and RMS,417 million in 2008 and 2007, respectively. The biggest
issuer in 2008 was Dewa Ringgit Sukuk Limited which issued
RM3.500 million worth of ijarah bond. Figure 7-4 shows the process
of issuance and the cycle of ijarah bonds where the issuer needs to
acquire assets.
The process of issuance and the cycle of ijarah bonds to fulfil the
requirements for fixed assets purchase by a business organization
may be described as follows:

1. The applicant (the bond issuer) will discuss and identify the asset
intended to be purchased from the seller and will determine the
conditions for the purchase of the commodity

2. The issuer will apply from the Securities Commission of

Malaysia approval to issue bonds. The approval is subject to
a number of conditions and requirements as set out by the
Securities Commission of Malaysia.
 ISLAMIC FINANCIAL MAKKlITS 403

FIGURE 7-4 Issuance and Circulation Process of Ijarah Bonds

for Fixed Assets

3. The issuer will discuss with and submit requests to the financier
or investor. Agreement on the conditions for financing includes
issuance expenditure and the pre-determined profit to be paid
to the investors.

4. The financier or investor makes the purchase and payment

according to the initial agreement made between the issuer and
the seller of the asset.

5. The financier will then rent the asset to the issuer according to
the rental price and other conditions agreed upon.

6. As documentary evidence of the arrangement is entered into by

both parties, the issuer shall issue the bonds. These bonds may­
be based on monthly, quarterly or semi annual rental payments
as agreed.
404 CHATTER 7

7. After receiving the bonds, the financier may resell them on the
secondary market based on the bai al-dayn principle.

8. At maturity, the issuer will amortize payments to the financier

holding the notes or the other parties concerned in the event
that the notes have been sold in the market.

An almost similar process is followed if the issuer requires

financing for circulating capital. In this situation, the issuer has to
identify either an individual asset or combined assets to be sold to
the financier. After the assets have been purchased by the financier
for cash, the financier will subsequently rent the asset to the issuer.
The issuer will then issue bonds of equivalent value to the rentals
which will be paid to the financier either monthly, quarterly or semi
annually.
The amount of rental payments depends on several factors
such as the type of asset, pre-determined return and the
agreed rentals. An extension of the ijarah principle is the i/arah
U’li-ii/tiim. Linder this principle, rental payments would be higher
because at the end of the rental period, the tenant would purchase
the asset at a pre-determined price, In addition to this, another
principle that is used in Malaysia is the i/arali rnmitaliiidi bit-tamlik
principle whereby ownership of the commodity is automatically
transferred to the tenant at the end of the rental period. Rental
transaction occurs between the commodity owner and the tenant
while the latter is responsible for bond issuance. The bonds issued
present documentary evidence to amortize indemnifies arising
from the rental of the asset concerned. However, there are situations
where a company or organization is established specifically to act
as the intermediary between the financier and the tenant of the said
asset or commodity. This organization is called special purpose
vehicle (SI’V) or special purpose company file establishment of
such an organization is sometimes required when transactions
involve the government or a global market, or when a relatively large
amount of assets are involved. At times its establishment becomes
 ISLAMIC FIKANCIAI MARKETS 405

necessary in order to fulfil legislative requirements. For instance,

when the government of Malaysia issued bonds with a five-year
maturity period valued at US$600 million in July 2002, Malaysian
Global Sukuk Inc. was established'as the special purpose vehicle.
Bond issuance using special purpose vehicle under normal
circumstances is as shown in Figure 7-5.

FIGURE 7-5 Issuance and Cycle of Ijarah Bonds Using Special

Purpose Vehicle

The SPV involved in this process is established either as a subsidiary

company by the party intending to issue the bond or a financial
institution possessing efficiency and expertise in handling the
business of bond issuance and administration. The steps involved
are as follows:

1. The customer enters into an agreement to sell an asset or

a combination of assets to the SPV according to conditions
mutually agreed upon. The seller will also agree to rent the
asset sold. The conditions which need to be taken into account
include the selling price, method of payment, rental payment,
rental period and options at the end of the rental period (option
to purchase the asset, or direct transfer of ownership to the
tenant or permanent ownership rights to the SPV).
406 CHATTER 7

2. The SPV will lake on the task of issuing the bonds and invite
investors to undertake the investment- Bonds will be issued
based on the assets purchased bv the SPV. The investors shall
have shared ownership of the asset and the SPV will also later
undertake the task of distributing profit to the investors.

3. The investors pay in cash when purchasing issued bonds.

4. The SPV will pay the purchase price to the seller after deducting
expenditure.

5. The SPV receives periodic rental payments from the seller on

the due dates.

6. The SPV will channel the rental payments to investors (i.e.

bondholders) in the form of profit on particular dates in line
with the receipt of rental payments.

When the government of Malaysia made the decision to issue

Islamic global bonds for the first time, various parties and
several processes were involved. The issuance of this bond worth
US$600 million involved a principal manager, The Hongkong and
Shanghai Banking Corporation. Other managers comprised ABC
Islamic Bank. Maybank International, Abu Dhabi Islamic Bank,
Bank Islam Malaysia, Dubai Islamic Bank. Islamic Development
Bank and Standard Chartered Bank. The bonds were listed on the
Luxemburg Stock Exchange and Labuan International Financial
Exchange. The first step involved was to establish a special purpose
vehicle or SPV. Die SPV was established by the Ministry of Finance
under the name Malaysia Global Sukuk Inc. in Labuan. which acted
as the issuer. Malaysia Global Sukuk appointed several parties to
take on the role of trustees, administrators handling payments and
collection of rentals, and the task of registering the issued bonds.
Various documents had to be prepared involving the relationship
between the seller and buyer of assets, tenant and rent provider,
and si/kid issuer and purchaser. Some of the important documents
 ISLAMIC FINANCIAL MARKETS 407

were issuer's declaration of trust, trust certificate or sukuk, sale

and purchase agreement of the asset, seller's declaration of trust,
master ijarah agreement and service agency agreement. The bond
issuance process is shown in Figure 7-6.

FIGURE 7-6 Process of Issuance and Cycle of the US$600

Malaysia Global Sukuk Bonds

The steps may be summarized as follows:

1. Malaysia Global Sukuk negotiates with the Federal Land

Commission to sell land and buildings owned by the
government of Malaysia. In this case the assets involved are
the Selayang Hospital, Tengku Ampuan Rahimah Hospital
in Kelang, the Government Complex and Housing Complex
408 cuaittk 7

at Jalan Duta. The sale and purchase agreement is signed,

and in this situation the property involved is termed as trust
property.

2. Malaysia Global Sukuk appoints a party who is responsible for

the issuance and administration of the sukuk (bonds). This party
will play an intermediary role between Malaysia Global Sukuk
and the bond purchasers.

3. The financial intermediary, on behalf of Malaysia Global Sukuk,

handles the bond issuance and receives collections from the
investors. The sukuk buyer or holder has ownership rights of
the trust property. The sukuk holder pays the face value for tire
sukuk as agreed upon.

4. The financial intermediary channels to Malaysia Global Sukuk

the acquired cash after deducting all the administration
charges.

5. Malaysia Global Sukuk issues payment to the Federal Land

Commission based on the purchase price of the asset. In this
case ownership is not transferred to Malaysia Global Sukuk, but
as a trustee it has the right of claim on the trust property. Thus,
Malaysia Global Sukuk has the right on all realized privileges
in future transactions.

6. Malaysia Global Sukuk undertakes a rental agreement with the

government of Malaysia and this agreement includes matters
related to maintenance, rental payments, amount and method
of payment. In this case, the basis for the rental rate is LIBOR
(London Inter-bank Offered Rate) plus the profit ratio.

7. Tire government of Malaysia makes rental payments to Malaysia

Global Sukuk on the stipulated dates.

8. From the proceeds of rentals, Malaysia Global Sukuk pays

dividends to the sukuk holders. The face value of the sukuk is
amortized at the end of the maturity period.
 ISLAMIC FINANCIAL MAKKFTS 409

9. The financial intermediary channels the rental payments made

by Malaysia Global Sukuk to the investors.

Bonds Based on Cagamas Mudharabah

Cagamas Berhad, established in 1986, started issuing Islamic bonds

called Cagamas Sanadat Mudharabah on 25 March 1994. Proceeds
from the sale of these bonds were used to purchase Islamic home
financing. As of 11 December 2001, Cagamas started to purchase
Islamic hire purchase financing and leases. As at 18 February
2009, die outstanding value of Cagamas Sanadat Mudharabah was
RM50 million. The issuance of Cagamas Sanadat Mudharabah bond
is shown in Figure 7-7.

FIGURE 7-7 Issuance and Cycle of Cagamas Sanadat

Mudharabah

7 6

The steps in the issuance process and the cycle of Cagamas Sanadat
Mudharabah bonds are as follows:

1. The qualified financial institution as listed by Cagamas will

inform Cagamas of its intention to sell and will quote the
410 CHATTER 7

highest rate of return to Cagamas, together with the estimated

sales value and the sales term.
2. Cagamas will appraise the selling price offered with potential
buyers (financial institutions) and the buyers will inform
Cagamas the rate of return that they expect
3. Cagamas will subsequently inform the seller the required rate
of return. If the rate is lower than the offered rate, then the
sale shall proceed. On the other hand, if the required rate is
higher than the offer rate, then the seller may either revise the
offer rate or cancel the sale altogether. If the offer to Cagamas
is higher than the required rate, then Cagamas will provide an
initial purchase contract that endorses matters such as value,
terms, difference between rates, date of purchase and service
fees calculation.
4. On the day that the decision of the tender is to be made known,
the seller may still cancel the sale if the buyer's required rate of
return is higher than the rate offered. On the other hand, the
sale will proceed if the seller agrees to the buyer's price. The
buyer must settle the purchase price with Cagamas.
5. Cagamas will transfer the sales proceeds to the seller.

6. When the payments are due from Ute borrower, the seller will
make these payments to Cagamas.
7. Cagamas will pay the buyer an amount as agreed in the
mudharabah contract between Cagamas and the buyer.

ORGANIZATIONS ASSOCIATED WITH

ISLAMIC FINANCIAL MARKET

The early history of the Malaysian financial market development

inav be looked at from two different angles, that is either from the
 ISLAMIC FINANCIAL MARKETS 411

perspective of the development of financial institutions or from the

perspective of the development of existing financial instruments
in the financial market. The first formal financial institutions
in Malaysia began when Chartered Mercantile Bank of India.
London and China (later named Merchantile Bank) established its
branch in Penang in 1856, which was subsequently followed by
tile establishment of a Chartered Bank branch in 1875. These banks
were set up to fulfil the banking needs of the mining and farming
industries. The services provided included trade financing, working
capital and money delivery between London, India and China. Local
commercial bank, Kwong Yik (Selangor) Banking Corporation,
was not set up until July 1913 (Bank Negara Malaysia, 1984). The
development of the financial and banking system in Malaysia had
passed through several phases with each phase having different
features and significance. The early era of development was followed
by the era of Japanese occupation, the pre-independence era, the
post-independence era, the pre-New Economic Policy era, the era
of the New Economic Policy, the post-New Economic Policy era, the
pre-economic crisis era and the post-economic crisis era. Starting
with branches of foreign commercial banks and followed by the
establishment of local commercial banks, the Malaysian banking
industry in 2007 consisted of 21 commercial banks, 11 Islamic banks
and 14 investment banks (Bank Negara Malaysia, 2007).
Since all trading transactions involve currency, it is thus
necessary' to briefly describe the development of money as a
medium of exchange and the institutions responsible for currency
issuance and circulation, in Malaysia, the use of money as a medium
of exchange began during the reign of Muzaffar Shah (1445-1459),
the fourth sultan of the Malacca Sultanate. When Malacca fell to the
Portuguese and then the Dutch, these colonists began to introduce
their own currencies (Bank Negara Malaysia, 1984). When the
British occupied Tanah Melayu (the Malay peninsula), they also
introduced their currency. The first organization established to
issue currency was the Board of Commissioners of Currency of
412 CHAPTER 7

Straits Settlements of Penang, Malacca and Singapore, which was

established under the Ordinance VIII of 1897. The Board continued
its function of issuing currency notes until 1967 when its currency
issuance function was taken over by Bank Negara Malaysia or the
Central Bank of Malaysia.
Bank Negara Malaysia (its original name was Bank Negara Tanah
Melayu or Central Bank of Malaya and was changed to Bank Negara
Malaysia when Malaysia was established in 1965) as the single
regulator of the banking system in Malaysia was established on
26 January 1959, in line with the independence of Malaya in 1957.
Since its establishment, Bank Negara Malaysia has experienced
several changes particularly with respect to its objectives and
functions. For instance, originally Bank Negara Malaysia also acted
as the supervisory body for the capital market in Malaysia, but this
responsibility was transferred to the Securities Commission in 1993.
Nevertheless, Bank Negara Malaysia maintains its function as the
regulatory body in the money market. This bank is also responsible
for the management of government securities and acts as a banker
and financial advisor to the government.
In contrast to the history of currency, the development of
the Malaysian capital market was pioneered by foreigners. For
instance, share trading in the country was introduced by the
shareholders of agricultural corporations such as Guthrie & Co Ltd
(1821), Fraser & Co Ltd (1873). Malakof Plantation Co Ltd (1879),
Inch Kenneth Rubber Ltd (1902) and Sime Darby & Co Ltd (1910).
Most of the shares of these companies were listed on tire London
Stock Market (Securities Commission, 2004) The first informal
securities organization in Malaysia was the Singapore Stockbrokers'
Association, which was established on 23 lune 1930. In 1937,
this association was re-registered as the Malayan Stockbrokers'
Association, but it did not trade public shares. In I960, the public
trading of shares began with the formation of the Malayan Stock
Exchange which was later renamed the Stock Exchange of Malaysia
in 1964. With the secession of Singapore from Malaysia in 1965,
 ISI AMIC EINANC1A1 MARKETS 413

it became known as the Stock Exchange of Malaysia and Singapore.

When the currency interchangeability between Malaysia and
Singapore ceased in 1973, the Stock Exchange of Malaysia and
Singapore was separated into Kuala Lumpur Stock Exchange
Board and Stock Exchange of Singapore. In 1976, the operations
of Kuala Lumpur Stock Exchange Berhad was taken over by the
Kuala Lumpur Stock Exchange, which was incorporated on
14 December of the same year as a company limited bv guarantee.
The Kuala Lumpur Stock Exchange Board was renamed the
Kuala Lumpur Stock Exchange in 1994. In 2004, the Kuala Lumpur
Stock Exchangebecameademutualized exchangeand was converted
to a company limited by its shares, called Bursa Malaysia.
Before 1993. the capital market in Malaysia was regulated
by multiple institutions and agencies including the Ministry
of Finance, Kuala Lumpur Stock Exchange Board, Registrar of
Companies, Bank Negara Malaysia, Capital Issues Committee and
Foreign Investment Committee. The two main legislations governing
securities regulations involved in the monitoring and supervision
of security-related matters were Companies Act 1965 and Securities
Industry Act 1973. The latter was replaced with Securities Industry
Act 1983.
Over time, the involvement of multiple agencies presented
some difficulties and complications as each had its own guidelines
and conditions for approval. Moreover, the many rules laid down
by each agency, when taken together, translated into a lengthy
and complex process. In 1988, a task force was set up to study the
development of the capital market in Malaysia. Based on this report,
a recommendation for the establishment of a securities commission
was made. In August 1991, a committee was set up to advise the
Ministry of Finance on the formal structure of the proposed new
commission. A report was presented to the Ministry of Finance in
February 1992. In August of the same year, the Cabinet approved the
working paper on the establishment of the Securities Commission
and two other bills, the Securities Commission Pill and the Futures
414 CHATTER 7

Industry Bill. All the related bills were passed by Parliament at the end
of 1992, and the Securities Commission was officially established on
1 March 1993 with the coming into effect of the Securities Commission
Act 1993, which also marked the dissolution of the Capital Issuance
Committee and the Panel of Take-overs and Mergers. With the
establishment of the Securities Commission, the corporate debt
market became jointly regulated by Bank Negara Malaysia and the
Securities Commission. The duplication of authority between the
two agencies was later identified and amendments to the Banking
and Financial Institutions Act 1989 and the Securities Commission Act
were made to address this issue. With these amendments in place,
the Securities Commission became the sole regulator)' body in the
corporate bond market in Malaysia in July 2001.

Securities Commission
Securities Commission of Malaysia (SCM) was officially established
on 1 Marell 1993 under the Securities Commission Act 1993 to fulfil the
demands and recommendations for a single regulatory authority
which is responsible for the systematic development of the capital
market as well as broader issues including investor protection.
In line with its objectives, SCM sets its mission statement as such:

To promote and maintain fair, efficient, secure and transparent

securities andfutures markets and tofacilitate the orderly development
of an innovative and competitive capital market (www.sc.com.my).

Since the main focus of SCM is on matters related to regulation, its

regulatory functions are as follows (www.sc.com.my):

1. Acting as registering authority for prospectuses of corporations

other than unlisted recreation clubs.

2. Acting as approving authority for corporate bond issues.

 ISLAMIC FINANCIAL MAKKKTS 415

3. Regulating all matters relating to securities and futures

contracts.

4. Regulating the take-overs and ipergers of companies.

5. Regulating all matters relating to unit trust schemes.

6. Licensing and supervising all licensed persons.

7. Encouraging self-regulation.

8. Ensuring proper conduct of market institutions and licensed

persons.

In order to facilitate SCM in the implementation of its responsibilities,

its organizational structure is broken down into several levels.
At the pinnacle of the organizational structure are the 9 members
of the Securities Commission. These members are appointed by the
Minister of Finance and comprise prominent figures in the industry.
As members of the Securities Commission, they are responsible
for setting policies related to the regulation and direction of the
capital market in Malaysia. The implementation of all the policies
comes under the jurisdiction of the SCM management which is
divided into two levels, senior managers and managers. Senior
management comprises directors and managers who lead the
divisions in SCM such as Market Supervision, Enforcement.
Corporate Resources, Strategy and Development, Issues and
Investments. Each department under these divisions is headed by
a head of department. The Department of Islamic Capital Market is
placed under the Strategy and Development Division.
In 2001, SCM published the Capital Market Master Plan which
presents a strategic roadmap for the development of the capital
market in Malaysia. This ten-year comprehensive plan charts
the strategic positioning and future direction of the Malaysian
capital market for the next 10 years, with the following vision
(Securities Commission, 2004):
416 CHA1TFK7

1. To be internationally competitive in all core areas necessary to

support Malaysia's basic capital and investment needs, as well
as its longer term economic objectives.

2. To be a highly efficient conduit for the mobilization and

allocation of funds.

3. To be supported by a strong and facilitative regulatory

framework that enables the capital market to perform its
functions effectively and provide a high degree of confidence to
its users.

Tlie master plan outlined 6 major objectives, 24 strategic initiatives

and 152 recom-mendations. The major objectives specified are as
follows:

1. To be the preferred fund-raising centre for Malaysian

companies.

2. To promote an effective investment management industry and

a more conducive environment for investors.

3. To enhance the competitive standing and efficiency of market

institutions.

4. To develop a strong and competitive environment for

intermediation services.

5. To ensure a stronger and more facilitative regulator)' regime.

6. To establish Malaysia as an international Islamic capital market

centre.

The master plan also contains 13 recommendations for action

forwarded by SCM to enhance the international competitiveness
position of Malaysia as an Islamic capital market. The action
recommendations are:

I Toactively pursuemoredvnamiceffortstointroducecompetitive
and innovative Islamic financial products and services.
 ISLAMIC FINANCIAL MARKETS 417

2. To facilitate efforts to introduce and promote a wider range of

Islamic collective investment schemes.

3. To further liberalize investment restrictions for the takaful

industry in order to facilitate greater mobilization of takaful
funds into the Islamic capital market.

4. To pursue efforts to mobilize untapped Islamic assets through

securitization,

5. To enhance efforts to increase the pool of Islamic capital market

expertise through training and education.

6. To establish a single Syariah advisory council for the Islamic

finance sector.

7. To establish a facilitative tax and legal framework for the Islamic

capital market.

8. To pursue efforts to develop an appropriate financial reporting

framework for the Islamic capital market in collaboration with
the Malaysian Accounting Standards Board.

9. To pursue more efforts to enhance the awareness of Malaysia

as an Islamic capital market at the domestic and international
levels.

10. To establish strategic alliances between Malaysia and other

Islamic capital markets.

11. To get the government and government-related entities to

consider issuing Islamic debt securities in the global market.

12. To pursue the listing of .Malaysian Islamic equity funds in the

international market.

13. To provide incentives to encourage the entry of foreign

intermediators and professionals with expertise in Islamic
capital market-related businesses.
418 CHATTER 7 ISLAMIC FINANCIAL MARKETS 419

In May 2007. the Capital Markets and Securities Act 2007 was passed instruments that are permissible must be developed. In view of
by the Malaysian Parliament and came into force in September of this problem, the Islamic banking industry has on many occasions
that year. The Act marked a major milestone in SCM's efforts to considered and proposed to have its own financial markets. The
strengthen the capital market's regulator}' framework in Malaysia. deliberation lingers on till today.
Among the key features of the Act are greater investor protection In certain countries, the governments have shown tremendous
through the enhancement of SCM's power to take civil and support and commitment to the establishment of a complete
administrative actions; and the introduction of a single licensing Islamic financial system. On-going efforts are taking place towards
regime as opposed to multiple separate licenses. this end. The financial market consists of four major components
SCM has conducted various activities towards the development and each component has been given due attention. In the money
of a comprehensive Islamic capital market in Malaysia as well as market. Islamic banks have been efficiently adjusting their liquidity
in the international market. SCM has also put forth guidelines for positions through a variety of Islamic financial instruments that
the issuance of Islamic securities. The guidelines cover aspects are now available. In addition, agencies such as the central banks
such as the need to appoint an advisor in the securities issuance and financial authorities are participating actively in the Islamic
process, the documents required when submitting the application money market through the issuance of negotiable certificates of
for approval, those qualified to issue Islamic bonds, appointment of deposit in order to resolve liquidity problems faced by Islamic
Syariah advisors, rating requirements, underwriting requirements, financial institutions. With respect to the Islamic capital market,
form of issuance and other requirements. Islamic financial instruments containing features of equity and
debt instruments have already been developed. The trading of
stocks on the exchange is permissible so long as it does not involve
stocks that are associated with businesses prohibited by Islam.
For debt instruments, Islamic bonds or sukuk have yet to be fully
developed. Nevertheless, sukuk based on the bai bithaman ajil, ijarah,
SUMMARY
salani and murabahah principles are widely used and issued in a
number of Muslim countries. As for the mortgage markets and
Tlie role of financial markets is to bring together buyers and users
forward markets, although these markets are still in an infancy
of funds. In the absence of a financial market, surplus units are
state, instruments are already being developed for them. However,
unable to channel their money to productive investments, and
the instruments are not extensively used in countries practising
deficit units are unable to obtain financing to meet their financial
Islamic banking system mainly due to the divergence of opinion
needs. This was indeed a problem faced by Islamic banks during
among ulama and Syariah experts on the legality and applicability
their early years of establishment. Even after more than 30 years
of certain transactions and principles.
of their establishment, this problem still looms over the Islamic
Malaysia has taken progressive steps in the establishment of an
banking industry as most countries do not yet have in place Islamic
institution with the main focus of developing the Islamic financial
financial markets. Since financial instruments associated with riba markets. In Malaysia, financial instruments for all four components
are not permitted by Syariah, it follows that alternative financial
of the financial markets have been successfully developed.
420 CHAPTER 7

Furthermore, Malaysia has set up several agencies which are directly

involved in regulating and supervising the financial markets. For
instance, the capital market is regulated and supervised by the
Securities Commission of Malaysia. In its Capital Market Master
Plan, the Securities Commission of Malaysia has detailed plans and
made recommendations for the development of the Islamic capital
market. It is envisaged that by the year 2010, Malaysia would have
in place a comprehensive and viable Islamic financial system.
Apart from the Securities Commission of Malaysia, Bank Negara
Malaysia is very much responsible for matters pertaining to the
money market financial instruments, while Cagamas Berhad plays
an important role in the mortgage market.

REFERENCES AND FURTHER READING

Affin-UOB Research. "Islamic Capital Market: Its Pillars of Faith."

Investors Digest (February): 26-32, 2004.

Ariff, Mohammad and Muhammad Abdul Mannan. Developing

A System of Islamic Financial Instruments. Jeddah IRT1. Islamic
Development Bank, 1990.

Bahrain Monetary Agency. Islamic Finance Review, Issue 6 (July

2004).

Bank Islam Malaysia Berhad. 2008 Annual Report. Kuala Lumpur.

Bank Negara Malaysia. Money anil Banking in Malaysia. Silver

Anniversary Edition 1959-1984. Kuala Lumpur: Economics
Department, 1984.

Bank Negara Malaysia. 2007 Annual Report. Kuala Lumpur

EIGari, Mohamed A. "Short term Financial Instruments based on

Salam Contracts" In Islatnis Financial Instruments for Public
 ISLAMIC FINANCIAL MARKETS 421

Sector Resource Mobilization. edited by Ausaf Ahmad and

Tariqullah Khan, 249-266. Jeddah (Saudi Arabia): IRTI. Islamic
Development Bank, 1998.

ElGari, Mohamed A. "The Qard Hassan Bank". Paper presented

at the International Seminar on Nonbank Financial Institutions:
Islamic Alternatives, Kuala Lumpur, March 2004.

Hussain, Abdul Rashid. "Islamic Benchmark Bonds." Working

paper presented at the Islamic Capital Market International
Conference, Kuala Lumpur, 15-16 July 1997.

Jordan Islamic Bank. Annual Report (various issues).

Kamali, Mohd Hashim. "The Futures Contract: A Syariah

Perspective." Working paper presented at the Islamic Capital
Market International Conference, Kuala Lumpur, 15-16 July
1997.

Kamali, Mohd Hashim. Islamic Commercial Law: An Analysis of

Futures and Options. Kuala Lumpur: Ilmiah Publishers, 2002.

Mannan. Muhammad Abdul. "An Appraisal of Existing Financial

Instruments and Market Operations from an Islamic
Perspective." In Developing a System of Financial Instruments,
edited by Mohammad Ariff and Muhammad Abdul Mannan.
75-104. Jeddah (Saudi Arabia): 1RT1, Islamic Development
Bank, 1990.

Muamalah Financial Consulting Sdn Bhd. Islamic Bonds and

Islamic Capital Market Course, Kuala Lumpur, 6 April 2004.

Osman. Mashitah. "Islamic Bond Market: State of Play in Malaysia."

Working paper presented at the Islamic Private Debt Securities
Seminar, Kuala Lumpur, 24-25 September 2001.

Pervez, Imtiaz Ahmad. "The Financial Instruments Used by Islamic

Banks." New Horizon. No. 46/47 (1996): 19-21.
422 chai*iik7

Qureshi, D.M. "The Role of Shariah Board Financial Instruments in a

Muslim Country." In Developing a System ofFinancial Instruments,
edited by Mohammad Ariff and Muhammad Abdul Mannan,
49-67. Jeddah (Saudi Arabia): IRTI, Islamic Development Bank,
1990.

Rosly, Saiful Azhar and Mahmood M. Sanusi. "Tire Application

of Bay' al-Inah and Bay' al-Dayn in Malaysian Islamic Bond:
An Islamic Analysis." International Journal of Islamic Financial
Services, Vol 1 No. 2 (July-September 1999).

Securities Commission of Malaysia. Annual Report (various issues).

Securities Commission of Malaysia. Resolution of the Securities

Commission Shariah Advisory Board, 2002.

Securities Commission of Malaysia. Capital Market Development in

Malaysia: History and Perspectives. Kuala Lumpur, 2004.

Usmani, Mohammad Taqi. "The Principle of Limited Liability From

the Shariah Viewpoint." A paper presented at the 7th Expert­
level Meeting on Islamic Banking, Kuala Lumpur, 27-29 July
1992.

www.bma.gov.bh

www.bnm.gov.my

www.cagamas.com.my

www.sc.com.my
 CHAPTER

ISLAMIC INSURANCE SYSTEM

Insurance is one of the important elements ofa country'sfinancial system.

However, the conventional insurance system which has been in existence
for about 3.1X10 years is not compatible with the religious beliefofMuslims
due to the presence ofelements of riba or interest, gharar or uncertainties,
and maisir or gambling. To meet the needs of Muslims, takaful, a form of
Islamic insurance which complies with Islamic principles was introduced.
This chapter discusses m detail the basic concepts oftakaful and its practice.
For comparison purposes, the operations of conventional insurance will
also be described.

INTRODUCTION

die Oxford Dictionary describes insurance as "an agreement that

a company makes to provide compensation for loss, damage,
or injury to a person or organization in return for a payment or
a series of payment (called premium) made in advance". In legal
terms, insurance is a contract by which the insured pays a specified
amount of money known as premium to another party, the insurer.

423
424 CHATTER 8

who in return agrees to compensate or indemnify the insured for

specific future losses as listed in the contract.
The original concept of insurance involves a cooperative system
which is based on collective agreement among a group of people
to jointly indemnify each other against loss that may befall any one
of them. Reimbursements are made from the fund to which each
participant within the group has contributed a certain amount of
money or premiums. The Islamic banking system was established
because of the presence of riba in the conventional banking system.
In the same light, Muslims are prohibited from transacting in the
conventional insurance system since conventional insurance does
not conform to the Syariah principles as it embodies the three
elements of gharar, maisir and riba.
Gharar is the element of "uncertainty" that exists in life
insurance policies and general insurance policies. The "uncertainty"
factor is the main feature in the contract or mu'qud'alaih, while in Islam
this point must be something which is clear and certain. Uncertaintv
is present in conventional insurance because the value and timing
of compensation cannot be determined and known at the time
the contract is made. For example, in conventional insurance, the
policyholder agrees to pay a premium to the insurance company,
and in return the company guarantees to pay compensation in the
event of a loss or catastrophe. However, the policyholder is not
notified of the method, source nor the amount of money that the
company would pay him. Under the Islamic insurance concept,
all parties to the contract need to know exactly how much they
must contribute and how much compensation they will receive.
In addition, gharar also exists when injustice or bias arises in the
agreement made by both parties. This situation occurs in both life
and general policies of the conventional insurance system. For
example, life insurance policyholders would lose their premiums
if they terminate their participating policies before they are eligible
for the cash surrender value. Similarly for general policyholders,
 ISLAMIC INSURANCE SYSTEM 425

the insurance company would be at an advantage in the event of a

policy cancellation within a short-term period.
Maisir or gambling is an extension of the "uncertainty" concept.
For example, a person buys a life Insurance policy with the hope
that his family or beneficiaries would receive a certain amount
of money upon his death. The policy undertaker, however, has
knowledge neither of the source of the money that would be paid
to his beneficiaries nor of how it would be obtained. The element
of riba exists in the conventional insurance system because the
insurance company guarantees to pay fixed returns on the money
contributed bv the policyholder.
Given the presence of these prohibited elements in the
conventional insurance system, Muslim ummah, particularly
those involved in business, are truly in need of a system which is
Syanah-compliant to cover them from losses incurred due to
unforeseen disasters, catastrophes or tragedies. According to
Muslim intellectuals, this concept of mutual help and cooperation
is indeed encouraged in Islam. This concept could be made the
foundation for the implementation of the Islamic concept of
insurance where elements such as collective responsibility, unity
and mutual interest form the core elements.

BACKGROUND OF THE CONVENTIONAL

INSURANCE SYSTEM

The word "insurance" was first used in 1651. Insurance means

the act or the system of guarantee of life or property based
on premium payments. The practice of paying premium as
cover for loss had existed since 1635, although it only involved
cover for loss of property and not for life. The word originates
from "insure" or "ensure" and was taken from enseurer, an old
426 CHAPTER 8

French word that means "to convince" or "to promise on oath".

After 1376, the word insuren or ensuren was used to convey the
meaning"togiveconsent"or"toprovideassurance" (Barnhart, 1988).
In general, the conventional insurance system today is of two types,
personal insurance and social insurance. Personal insurance is
basically a voluntary insurance scheme provided to individuals to
cover them against any disaster or loss. Although at times personal
insurance schemes are offered by the government, more often this
type of insurance is provided by private companies. One of the
main features of this type of insurance is voluntary involvement
and risk transfer based on the contract of agreement undertaken
between the insurance company and the individuals participating
in the insurance schemes. In contrast with personal insurance
schemes, social insurance is a compulsory scheme which is usually
administered by the government. Benefits of the social insurance
scheme are normally determined by legislation and emphasis is
placed on the concept of social sufficiency. An example of a social
insurance programme in Malaysia is the Social Security Organisation
or SOCSO and in the United States, the Social Security System.
Personal insurance may be categorized into two types, private
insurance and property insurance. Private insurance provides
cover against losses related to life and health, while property and
liability insurance is cover for losses on property as a result of a
disaster or catastrophe. A method, similar to this concept of mutual
assistance and shared responsibility in society, existed around
25(K) BC in the Egyptian society. Under this method, every member
of society would contribute funds to help the less fortunate,
including financing burial expenses or financing cost of medical
care for those suffering from serious illnesses. This concept was
also adopted by the Greeks and Romans.
The basic concept of insurance for property came into
existence around 3000 BC (Vaughan and Vaughan, 1999). During
this period, Chinese merchants practised risk-sharing techniques
in transporting their goods. When travelling across treacherous
 ISLAMIC INSURANCE SYSTEM 427

waters, the merchants would redistribute their goods across many

ships in order to limit the loss due to ship capsizing. In the event of
a capsize, the loss incurred would not be centred on certain parties
only, but instead it would be shared by many parties and was
therefore made manageable.
Besides this practice, the concept of risk transfer was also
recorded in the Code of Hammurabi (around 1800 BC). According to
this Code, if a trader or merchant receives a loan to purchase goods,
he is required to pay the lender an additional sum in exchange for
the lender’s guarantee to cancel the Ioan should the goods be stolen.
A similar system was applied by the Phoenicians and Greeks in
their seaborne commerce. The borrower was given the option to
pay high interest rate on the Ioan received in exchange for the
creditor's guarantee to cancel tire loan if the ship or cargo vanished
at sea or was stolen. This contract was known as bottomry contract
if ships were used as a guaranty’ and respondentia contract if cargo
was presented as the guaranty.
Marine insurance is the first insurance of modern times to
be introduced. The use of this insurance started in Italy in the
13th century and spread to other European countries and later to
England. Unlike the bottomry contract which was associated with
loans, this method involved free trade. Ship owners and traders
who wished for protection would list the name of the ship, its cargo
or load, the destination and other important information on a piece
of paper and would display such information to the public.
The partv who was willing to bear the risk would write his name
under the paragraph that outlined the types and amount of risks
and other terms of agreement. The practice of writing under the
paragraph or writing under later led to the creation of the term
underwriter.
Fire insurance as known today originated in 1591 in Germany.
However, the Great Fire of London of 1666 demonstrated the
urgent need for fire insurance and was the major contributor to
the development of this type of insurance. In the aftermath of this
428 CKAITBK 8

disaster, a medical doctor by the name of Nicholas Barbon who

was involved in redeveloping the city of London after the great fire,
opened an office to insure houses and buildings. Casualty insurance,
meanwhile, was said to have been introduced in 1848 when the
English Parliament approved the establishment of a company to
sell insurance for the protection of train passengers.
The history of life insurance began on 18 June 1536 when a group
of guaranteed sponsors in London issued a life insurance policy to
a man. The period of coverage was for a year at a value of £400.
The man died within that period and the guaranteed sponsors
paid up as per the agreement. The first insurance company was
established in 1699 in London, called the Society for the Assurance
of Widows and Orphans.
As in most countries in the world, insurance service in Malaysia
is divided into two, namely life insurance and general insurance.
Life insurance involves life coverage and coverage for other
unforeseen disasters which cause the loss of income due to
permanent disability as well as physical impairment. General
insurance, on the other hand, involves coverage for loss of property
resulting from fire, theft and other disasters.
There is no information available as to when insurance was first
introduced in Malaysia (formerly Malaya). However, branches of
insurance companies belonging to England, America and other
countries dominated the insurance business in the big towns of
Malaya (Bank Negara Malaysia, 1989). If the development of trade
involving tin and rubber were to be taken as a basis of the origins
of the insurance business, then the late 18lX)s and early 1900s may
be regarded as the beginning of the insurance business in Malaysia.
In fact, the first branch of a foreign commercial bank was set up in
Malaya in 1909. Local insurance companies were first established
in the 1950s. In 1963, there were 6 insurance companies and by the
end of 2007 as many as 126 licences had been issued. Out of the
total licences issued, 41 companies were direct insurers, 7 were
professional reinsurances, 34 were insurance brokers, 37 were
 ISLAMIC INSl'KANCt SLS11M 429

adjusters (valuators) and 7 were financial advisors. In the direct

insurance business, 9 companies conducted life insurance business,
26 companies conducted general insurance business, while
7 conducted both life and general insurance by the end of 2007.
The number of registered agents was 78,587 for life insurance and
39,165 for general insurance. Total assets of insurance companies
were RM122,550.3 million, with RM102.601.3 million belonging
to life insurance and RM 19,949 million to general insurance as at
end of 2007. The number of new policies issued for 2007 alone was
1,337,312, worth a total of RM186,327.2 million. This made the total
number of policies issued up until 2007 to be 10,909,194 with an
insured value of RM723,000.7 million. The amount of claims paid in
2007 was R.M4.606.3 million (Bank Negara Malaysia, 2007a).
Before 1961, the operations of insurance companies in Malaysia
were governed under the Life Assurance Companies Ordinance
1948 and Fire Insurance Companies Ordinance 1948. Due to the
emergence of certain unhealthy practices in the insurance industry,
the government introduced a new legislation known as the Life
Assurance Act 1961 which was later amended to become Insurance
Act 1963. As the insurance industry continued to expand, more
effective supervision and regulation of the industry was required.
Recognizing this, the function of regulating and supervising the
insurance industry was transferred to the Central Bank of Malaysia
commencing 1 April 1988 with the appointment of the Governor of
the Central Bank as the Director General of Insurance.
Prior to 1988, the insurance industry was under the purview of
the Treasury. Insurance laws were further consolidated when the
Insurance Act 1963 was amended and replaced with the Insurance
Act 1996. Under this Act, a range of regulations and authority
were provided to the Central Bank of Malaysia to approve the
appointment of director and chief executive officer, selling or buying
of big share capital interests, establishment of offices and subsidiary
companies, and appointment of auditors and valuators. Apart from
the Act, insurance companies are also regulated under the Insurance
430 CIIAl’l EK 8 ISLAMIC INSURANCE SYSTEM 431

Regulations 1966. Since its inception, several amendments have been (iii) Adopt international business best practices and management.
made to the regulations, especially when changes were required
(iv) Be in tune with the latest phase of innovation with a wide
in the insurance industry during the economic crisis between 1997
range of products at competitive prices for consumers.
and 1998.
The arrival of the new century brought a range of challenges to (v) Conduct business through distribution channels of wide scope
the industry, particularly, globalization. However, by international and variety for the convenience of consumers.
standard, the insurance industry in Malaysia can be considered
(vi) Display high standards of professionalism and ethics.
relatively small. Some of the challenges identified are as follows
(Bank Negara Malaysia, 2001): (vii) Be more productive and cost effective.

(i) Increasing competition from traditional companies in line Bank Negara Malaysia has presented various recommendations
with the global trend towards mergers and consolidation that towards the achievement of the above goals. The recommendations
creates international insurers which are much bigger in size, would be achieved in three phases as follows:
more skilled and more centred on core competency areas.
(i) Building the capacity of domestic insurers.
(ii) Competition from new companies such as asset managers,
(ii) Promoting mergers and reinforcing incentives to improve
captive insurers (general insurance), independent financial
performance.
advisors and internet companies. By not depending on
middlemen in the insurance business, these companies are (iii) Motivating innovations through liberalization and
able to improve their product range and performance as well progressiveness.
as bringing down costs.
One of the recommendations in the first phase is to allow qualified
(iii) Self-adjustment and adaptation to suit technological insurance companies to sell takaful products. This implies that the
advancement which in principle has changed the way takaful system is set to play a major role in the insurance industry
businesses are administered. in Malaysia.

(iv) Meeting the needs of more sophisticated and knowledgable

consumers.

In light of future challenges, it is hoped that the insurance industry HISTORY AND DEVELOPMENT OF
in Malaysia would be able to achieve the following goals: THE ISLAMIC INSURANCE SYSTEM
(I) Be the long-term savings initiator which is resilient and
effective in order to support economic growth. Islamic insurance system is known as takaful. Thus, in the
discussion of Islamic insurance the term takaful is used. Takaful is
(ii) Possess a strong financial position in facing market fluctuations
a system created to provide protection against disasters similar
and competition pressure.
to the protection provided by the conventional insurance system.
432 CHAPTER 8 ISLAMIC INSURANCE SYSTEM 433

Since the conventional insurance system cannot serve the Islamic Islamic Takaful Company were created. As with Islamic banks,
ummah, takaful becomes the alternative. In essence, takaful is takaful companies have expanded their operations to include both
an extension of the concept of mutual assistance as well as the Muslim and Western countries. For instance, a takaful company,
concept of blood money as practised by the Arabs before Islam called First Takaful USA. was set u[5 in the United States, At the
was established. It is believed that the concepts of compensation end of 2007, there were more than 130 takaful companies operating
and group responsibility are accepted by Islam and the Prophet worldwide with 59 operators based in the Gulf Cooperation
(p.b.u.h.). Muslim intellectuals and jurists are of the opinion that Council countries of Bahrain (15), Kuwait (11), Qatar (5), Saudi
the concept of joint responsibility in the aqila system as practised Arabia (22) and the United Arab Emirates (4). Apart from these
by the Muhajirin (Muslims from Mecca) and Ansar (Muslims in countries, takaful companies have also been established in
Medina) laid the foundation for takaful. It is also believed that Iran (17 takaful operators), Sudan (15 takaful operators), Egypt
takaful was first introduced when Muslim Arabs expanding their (6 takaful operators), Jordan (3 takaful operators), Bangladesh
trade to India, South East Asia and other Asian countries, mutually (6 takaful operators), Pakistan (4 takaful operators) and Sri Lanka
agreed to contribute to a fund to cover members in the group who (2 takaful operators). In the South East Asian region, takaful
incurred mishaps or robberies along the numerous voyages. (Long companies are already operating in Malaysia, Brunei, Singapore,
distance journeys are normally associated with huge losses arising Indonesia and Thailand.
from a multitude of misfortunes such as disasters or robberies.) In Malaysia, a special task force was set up in 1982 by the
This early takaful practice bore some similarities to the marine government to study the viability of establishing a takaful company.
loans practised by the Greeks. Marine loan was said to be the Following the recommendations of this task force, the Takaful Act
foundation for the concept of modem conventional insurance. was enacted in 1984. Subsequently, the first takaful operator, Syarikat
Under the marine loan concept, money was loaned to shipowners Takaful Malaysia Berhad, was established in November 1984 and
and was repayable only upon safe completion of a voyage. High commenced operations in July 1985. The monopoly status enjoyed
interest rate, which was paid for successful voyages, was not only by Syarikat Takaful Malaysia for almost ten years came to a halt
regarded as cost of capital, but also as risk of capital loss. Although when in 1994 the government decided to introduce competition to
this practice of conventional insurance system is unacceptable in the industry by issuing licence to MNI Takaful Sdn Bhd to offer
Islam, Muslim jurists do not prohibit the concept of insurance itself. insurance products founded on Syariah.
The reason is that the core of takaful is the element of cooperation The rapid development of the takaful system in Malaysia
which is absolutely encouraged in Islam. motivated and inspired neighbouring Muslim countries to
Alongside the prolific establishment of Islamic banks, takaful implement the system. Brunei Darussalam, for instance, allowed
institutions were created to provide insurance cover to Muslims. the establishment of Takaful IBB Berhad in 1993. This was
The first takaful company was established in 1979 in Sudan. In the followed by the establishment of Insurance Islam TAIB Sdn Bhd
same year, Arabic Insurance Company was established, followed and Takaful Bank Pembangunan Islam Sdn Bhd. In Indonesia,
by the establishment of Dar al-Mal al-lslami in Geneva in 1981. Syarikat Takaful Indonesia which came into existence as a result
In 1983, Luxembourg Islamic Takaful Company and Bahrain of a joint effort between Syarikat Takaful Malaysia Berhad and
its Indonesian counterpart, began operations in August 1994.
434 CHATTER 8

From only 5 takaful operators in 2002, the numbers have now reached
38 operators in the country. Thailand is another emerging takaful
market with three companies providing Islamic insurance, namely
Dhipaya Insurance, Finansa Life Assurance and Kamol Insurance.
Meanwhile there are three companies providing takaful cover in
Singapore, that is HSBC Insurance, NTUC Income and United
Overseas Insurance.
On 28 October 1995, the ASEAN Takaful Group (ATG) was
established as an informal body to foster and enhance greater
mutual cooperation among ASEAN (Association of South East
Asian Nations) takaful operators in terms of exchange of information
and retakaful business. In 2003, ATG amended its constitution to
accommodate memberships from outside the ASEAN region and
changed its name to Asia Takaful Group. Recently, it was registered
as a company limited bv guarantee and renamed Global Takaful
Group. In order to realize the retakaful business, ATG Retakaful
Pact was established and began operations on 1 October 1996.
On 17 May 1997, Asean Retakaful International Ltd (ARIL) was
incorporated and registered under the Offshore Insurance Act
1990. ARIL began its operations as an offshore entity in Labuan in
September 1997 with an authorized capital of US$50 million and
paid-up capital of US$4 million, all of which were contributed by
Syarikat Takaful Malaysia. The establishment of ARIL is aimed
at enhancing cooperation in addition to subsidizing retakaful
requirements among takaful operators in ASEAN. In addition, it
is hoped that the retakaful facility would be used by other takaful
operators outside of ASEAN.
At the international level, at the D-8 (Group of eight Developing
Muslim countries) Summit held in Istanbul in June 1997, the D-8
member countries (Bangladesh, Indonesia. Iran, Malaysia, Egypt,
Nigeria. Pakistan, Turkey), agreed for Malaysia to host the meeting
of the task force associated with finance, banking and privatization.
Bank Negara Malaysia was asked to look into the possible areas
of cooperation which Malaysia could offer to the Organization of
 1SI.AMIC INSLRANCI S»SH M 435

Islamic Countries (OIC). In fulfilling this responsibility, two aspects

related to takaful offered by Malaysia were information exchange
and training. Malaysia yet again played a significant role in the
expansion of the takaful system at'the international level when in
1999 a Malaysian takaful company assisted in the establishment of a
takaful company in Sri Lanka.
In line with the challenges of the new century. Bank Negara
Malaysia has also outlined a number of strategies to expedite the
development of the takaful business. Among the strategies are:

(i) To increase the number of takaful operators.

(ii) To improve the framework for the supervision of takaful.

It is expected that Bank Negara Malaysia would be issuing new

takaful licences. The consequent increase in the number of takaful
operators is to help speed up the achievement of the following
goals:

(i) To expedite the development of takaful businesses in line with

the more developed Islamic banking system.

(ii) To promote market competition in pricing, product innovation,

customer service and operation efficiency.

(iii) To increase Syariali-based retakaful programmes among takaful

operators.

(iv) To highlight ASEAN Retakaful International Ltd as the

foremost retakaful operator in the region.

(v) To make Malaysia the centre of takaful expertise.

The supervision framework meanwhile aims to create a healthy

takaful industry, and the main aspects emphasized are as follows:

(i)To review the Takaful Act 1994 and related legislation in order
to address existing weaknesses.
436 CHAl'TlxS

(ii) To progressively increase the statutory minimum paid-up

capital of the takaful operators, in line with their capacities
to develop and undertake higher risks. The increase in basic
capital for the takaful operators would improve their capacities
to compete more effectively in the domestic market and
subsequently at the international level.

(iii) To introduce accounting standards for takaful business and

drafting of a Model Account Bill for takaful operators.

(iv) To monitor and improve on the uniform code of ethics and

market practice for takaful operators.

As at the end of 2(X)8, there were eight takaful operators in Malaysia,

namely Syarikat Takaful Malaysia Berhad (established on
29 November 1984), Etiqa Takaful Berhad or formerly known as
Takaful Nasional Sdn Bhd (established on 20 September 1993),
Takaful Ikhlas Sdn Bhd (established on 21 April 2003), CIMB
Aviva Takaful Berhad or formerly known as Commerce Takaful
Berhad (established on 7 April 2006), Hong Leong Tokio Marine
Takaful (established on 19 June 2006), Prudential BSN Takaful
Berhad (established on 8 August 2006), HSBC Amanah Takaful
Sdn Bhd (established on 11 August 2006) and MAA Takaful Berhad
(established on 1 July 2007). Total assets of these takaful operators
were RM8.815.8 million as at the end of December 2007 with market
penetration of 7.2%. Out of the total assets, RM7,442.7 million were
from family takaful and RM1,373.1 from general takaful. Throughout
2007, a total of RM2.557.8 million of new contribution income was
made. For the year ending 2007, the net benefits and claims payments
for family takaful was RM534.2 million, while for general takaful it
was RM2I8.5 million. Hence, takaful assets and net contributions
recorded an average growth rate of 27% and 19% respectively from
2003 to 2007 (Bank Negara Malaysia, 2007b).
 ISLAMIC INSUKANCt StSTTM 437

PHILOSOPHY, PRINCIPLE AND OPERATIONAL

CONCEPT OF TAKAFUL

The word "takaful" originates from the Arabic word kafalah meaning
"mutually guaranteeing" or "mutually caring for one another". The
verb kafalah means to protect or look after someone's interest or to
provide a guarantee to someone. When "la" is added to the word,
it conveys the idea of two parties who provide mutual guarantee to
one another.
When the task force on the "Study for the Establishment of
an Islamic Insurance Company in Malaysia" presented its report
consisting of recommendations to establish Islamic insurance
companies to the Prime Minister of Malaysia in 1984, the suggested
philosophy was as follows:

Tlte philosophy of Islamic insurance places importance on

sincerity' of intention to assist one another. Thus, the financial
contribution for this purpose is based on the spirit of fabarru'
(donation). In line with this spirit and the principles of mutual
responsibility, cooperation and protection and conforming to
the qualities of selflessness and not being driven towards mere
acquisition of profit, the Task Force has decided that the Islamic
insurance philosophy is to be as follows:

The internalization of the spirit of mutual responsibility,

cooperation and protection in activities of the society towards the
prosperity of the ummah and the unity ofsociety.

Although the modem takaful system was just introduced in 1979, the
concepts of mutual assistance and cooperation had actually been
advocated since the early years of Islam. Muslim jurists and ulama
are of the view that the concept of insurance is implementable due
to the following factors:
438 CHATTER 8

(i) The policyholders cooperate among themselves for the

common good.

(ii) Every policyholder pays an amount required as contribution

to help those in need of assistance.

(iii) Losses are divided and liabilities are spread according to a

community pooling system.

(iv) The element of uncertainty is eliminated in respect of

subscription and compensation.

(v) No one member of the system shall derive benefits at the

expense of others.

THE TAKAFUL PRINCIPLE

in Malaysia, there are three core principles in takaful, namely:

(i) mutual responsibility,

(ii) mutual cooperation and

(iii) mutual protection.

The quality of being mutually responsible is advocated in Islam.

Muslims are not only responsible towards the Creator, Allah (s.w.t.),
but also towards other creations. In the context of takaful, the feeling
of responsibility towards one another is the foundation of solidarity
of Islamic community. The principles are illustrated through the
following haditlis compiled in Sahih Bukhari and Sahih Muslim.

The atlit tide of belieivr and the feeling ofbrotherhood to one another is
like that ofa single body. When one member of the My is hurt, it will
have an effect on the whole body. Situation of the believers, as regards
 ISLAMIC INSVRANCl S»S I I SI 4.W

their being merciful and kind and showing low among themselves,
resembles one body. so that ifany part of the body is not well, then the
whole body is affected.

The relationship between one believer and another (in a community)

is like that of a building where one part of the building strengthens the
other parts. A believer to another belietvr is like a building where each
part enforces the others.

Each ofyou has a responsibility and each ofyou is responsible towards

those under your responsibility. Each one of you is a person of
responsibility, ami each one ofyou is responsible for those under your
responsibility.

Tlie second principle by which takafid operations is bound is mutual

cooperation. This quality of cooperation among the ummah is also
advocated in Islam. The principle of cooperation is established
through the Quran and Sunnah. For example, verse 2 of Surah
al-Maidah and verse 177 of Surah al-Baqarah touch on the matter of
cooperation.

...Help ye one another in righteousness and piety, but do not help one
another in sin and rancour...

It is not righteousness that you turn your faces towards East or West,
but righteousness is whoever believes in Allah and the Last Day, and
the Angels, and the Book, and the Messengers: and spending out of
his wealth for His love towards kin, and orphans and the poor and
the wayfarer and those who ask and the freeing of slaves and those in
debt: to be steadfast in prayer and practice regular charity: to fulfil the
contract which you have made: and to be firm and patient in pain or
suffering and adversity and throughout all periods of panic. Such are
the people of truth, the God-fearing.

The Sunnah has also established the principle of cooperation

as illustrated in the compilation of Hadilh narrated by
Abu Dawood:
440 CHATTER 8

Whosoever fulfils the intention of a brother, Allah will fulfil his

intentions. (Yasir Qadhi, 2008)

The third principle is the principle of mutual protection from

disasters. Disaster and prosperity are both sent by Allah (s.w.t.),
and the advocation to help one another is found in the following
Hadith narrated by Ibnu Majah:

Indeed a believer who can give security and protection to the life and
property of mankind. (Al-Khattab. 2007)

However, in line with current developments, the implementation

of the takaful system today is based on several principles, that
is, principles grouped under the Syariah principles and general
principles in Islam. For example, while the original principle of
takaful was based on the concept of collaboration or ta'awun, today
it is managed based on the al-takjiri principle. Hence, just as the
conventional insurance system is based on the commercial concept
and operated bv big companies, the takaful system is also operated
by business companies whose goal is to mobilize hinds for the
purpose of making profit.
In takafid operation, this principle involving commerce is
important because the fund contributed by takafid participants
need to be mobilized for growth purposes. It the accumulated
fund remains idle, there is a big possibility that the fund could
soon become depleted and eventually lead to the dissolution of
the cooperative agreement. Thus, for the sake of the economic-
development of the ummah and Islam, the accumulated fund
would have to be multiplied through business or other economic
activities.
The implementation of the takafid system involves two parties,
namely the party who manages the operation and administration
of the fund, and the party who participates in it. The party who
manages the lakafid company may choose which concept or model
to apply. In general, lakafid operations are confined to the principles
of takjiri, mudharabah, wakalah and tabarru.
 ISLAMIC INSURANCE SYSTEM 441

Takjiri

Takjiri is an Arabic word meaning commerce. Given that the

operation of takaful is based, on the concept of commerce,
takaful operators must hence observe Islamic business practices.
Business areas prohibited by Syariah cannot be ventured into.
Further, the fund contributed by takaful participants cannot be
invested in riba-based financial institutions. Islamic business
ethics and morals must be strictly adhered to and no elements
of exploitation must exist between takaful operators and the
participants. The concept of justice and fairness must also be
observed. Management of takaful companies must also avoid
the tendency for mere profit acquisition. In brief, all the Islamic
principles and philosophy must be conformed to at all times.
Systematic management methods and cautious investment
would reduce risk of loss, resulting in the business rendering
profit to both parties, that is, the operator and participants.

Mudharabah

Under this concept, the takaful operator acts as the mudarib

or entrepreneur who is appointed by the takaful participants.
The takaful participants, on the other hand, act as shaib-ul-maal
or investors or fund contributors. Participants appoint the
takaful operator to mobilize their fund in businesses which are
not prohibited by Syariah and the profit obtained is shared by
both parties according to a mutually agreed ratio. In this takaful
system, claims by a participant depend on the types of cover
he participates in. Contributions need to be made monthly, or
yearly, or in one lump sum. These contributions are known as
ra's-ul-mal'.

Wakalah

Under the wakalah or representative concept, the takaful operator

acts as the administrator of the fund and manages the fund in
trust on behalf of the participants. The takaful operator earns a
442 CHATTER 8

fee for services rendered using the u/r principle and has no right
to receive profit from the fund. All acquired profit is given back
to the takaful participants.

Tabarru

Tabarru is an Arabic word which means to donate, to contribute

or to give to charity. The tabarru principle is the essence of the
Islamic takaful system. In the takaful system, participants make
two kinds of payment, namely payment for their personal
savings and a donation or contribution which would aid other
participants who are faced with difficulty or disasters. It is this
donation that would be used by the takaful company in making
payments to fellow participants who suffer from a defined loss.

Operational Concept
There are four concepts or models of cover operation offered by
takaful operators, namely the non-profit concept, mudharabah concept,
wakalah concept and combination concept (Abu Bakar, 2004).

The Non-Profit Concept

This concept involves a group of individuals in a communitv who
mutually agree to provide sincere contribution to members of the
community faced with disaster or misfortune. The contributions
paid by the participants are in the form of donation or commonly
known as tabarru. This earnest contribution may be done
systematically within a set period of time, or only administered
at the time that a member faces a misfortune. Takaful using this
method can also be conducted in a modem and organized way.
If this takaful is managed by an organization, then the wakalah
concept would still be applied. This means that the operator
 ISLAMIC INSURANCE ■SYSTEM 443

would act as the representative who manages the fund and

receives payment for services rendered. However, the participants
will not receive any return on the pool of fund which they have
contributed. An example of a company using this method is the
Al Sheikhan Takaful Company in Sudan.

The Mudharabah Concept

The mudharabah concept refers to the cooperative risk-sharing

between the operator and participants. The operator is appointed as
the entrepreneur who mobilizes the fund in economic activities, and
profits obtained from underwritings would be shared by both the
operator and participants. As with other models, the participants are
required to contribute to two types of accounts, the general account
and the tabarru account. Under this concept, the operator does not
impose any service charge or management charge for the services
rendered or tasks handled when operating the takaful. Management
or administration charge is imposed on the shareholders’ fund.
In Malaysia, this concept is used by Syarikat Takaful Malaysia.

The Wakalah Concept

Under the wakalah concept, the operator acts as the agent who
manages the contributions and mobilizes the participants’ fund.
A service fee is imposed by the operator for the services rendered
and the operator or agent does not share in any surplus of the
fund. All risks related to the business undertaken would be borne
by die participants. A service fee would also be imposed by the
operator on the profit from the investment of the participants’ fund.
The takaful operator offers services such as general takaful and family
takaful. In Malaysia, this concept is practised by Takaful Ikhlas.
444 CHATTER 8

The Combination Concept

The combination concept is based on the merging of the wakalah
and mudliaral’ali principles. The takaful operator acts as the
representative who manages participants' fund and a service fee
is imposed for the services rendered. Profit obtained from the
investment undertaken using participants' fund would be shared
between the operator and participants. Hence, the wakalah model
is used for underwriting activities while the mudharabah model is
used for investment activities.

TYPES OF TAKAFUL COVER

As explained earlier in the chapter, the history of conventional

insurance cover began when several members of a community
with mutual interest came together to protect their community
from possible disasters, which if occurred would result in loss of
property or lives. In the event that the latter occurs, it is important
that the interests and welfare of the heirs or beneficiaries of the
deceased (or insured) be taken care of. It is for this reason that
conventional insurance companies provide two types of coverage,
namely coverage for mishaps that could befall individuals, and
coverage for loss incurred on property. Individuals are covered by
way of life insurance, and property is covered through a general
insurance scheme. Takaful offers similar types of coverage. 1 lowever,
for individual coverage it is referred to as family takaful rather than
life insurance. Property coverage is termed as general takaful. Let us
now examine these two types of coverage.

Family Takaful

Family takaful is a scheme involving collaboration between a

number of individuals in a community with the goal of helping one
 ISLAMIC INSURANCE SYSTEM 445

another in the event of a disaster that may be inflicted upon any one
of them. In general, there are three types of takaful family cover:

(i) Ordinary collaboration ,

(ii) Collaboration with savings

(iii) Collaboration based on specific groups

In ordinary collaboration, a group of people reciprocally-

guaranteeing each other agrees to contribute a premium to the
takaful fund. The contribution is in the form of a donation to the
fund of the group. In the event any member is inflicted with a
mishap or disaster, the takaful operator will make payment from
the pool fund to the contributor or his beneficiaries subject to the
stipulated terms of agreement.
In the "collaboration with savings" type of cover, apart from
mutually helping one another in the group, participants also deposit
savings which is withdrawn later at the end of a certain time frame.
Tliis type of contribution hence involves two kinds of payment,
namely payment for the purpose of personal savings, and payment
for sincere contribution or donation to other members of the group
in the event of a mishap or disaster.
In "collaboration based on specific groups", participants
consist of those from community groups that wish to create a
pact based either on the same ethnicity, organization or the same
district. In cases like this, the terms would be formulated such that
optimum benefit would be enjoyed by the particular group alone.
Contributions may be made jointly, that is by the organization and
the individual involved.
Syarikat Takafui Malaysia offers family takaful products as
follows (www.takaful-malaysia.com.my):

• Family Takaful Plan

• Dana Saham Takaful Plan

• Ma'asyi Takaful Plan

44b CHATITR 8

• Workers' Fund Takaful Plan

• Mortgage Takaful Plan

• Personal Accident Takaful Scheme

• Takaful myMedicare

• Hawa Takaful Plan

• Rawat Takaful Plan

• Sihat Takaful Plan

• Takafu) myMedicarel

• Siswa Takaful Plan

• Waqaf Takaful Plan

For group family takaful, Syarikat Takaful Malaysia offers the

following products:

• Group Rawat Takaful Plan

• Group Personal Takaful Plan

• Group Family Takaful Plan (credit)

Takaful Ikhlas has die following family takiiful plans (www.takaful-

ikhlas.com.my):

• Ikhlas Savings Takaful

• Ikhlas Education Takaful

• Ikhlas Education Takaful Classic

• Ikhlas Lifestyle Takaful

• Ikhlas Capital Investment-Linked Takaful

• Ikhlas Premier Investment-Linked Takaful

Ikhlas Wanita Takaful

 ISLAMIC INSURANCE. SYSTEM 447

General Takaful

General takaful is a short-term contract which provides prolection

against material loss or damage to assets belonging to participants,
arising from a catastrophe or misfortune. This means that a group
of individuals collaborate to contribute to a fund for the coverage
of losses inflicted upon properties of members in the collaborative
group. General takaful may be grouped according to types of
insurance, namely fire takaful scheme, accident takaful scheme,
marine takaful scheme and engineering takaful scheme. As an
example, Svarikat Takaful Malaysia offers general takaful services
as follows (www.takaful-malaysia.com.my):

• Fire Takafiil Scheme: Coverage is provided for buildings,

machineries, household content and stocks as a result of fire,
lightning or domestic gas explosion. Coverage is also provided
for losses resulting from disasters such as riots, strikes,
earthquakes, floods, storms and other natural disasters which
are beyond human control.

• Motor Takaful Scheme: Coverage is given to vehicle owners for

losses or damages caused by theft or accident concerning their
vehicles.

• Employer Liability Takaful Scheme: Coverage is provided to

employers for losses which have to be borne resulting from
compensations which they have to pay out to the public,
employees or others due to negligence on their part.

• Machinery Breakdown Takaful Scheme: Coverage is provided to

machinery owners, in particular factory operators, for losses
due to loss of income resulting from damage of machinery,
explosions, etc.

• Marine Cargo Takaful Scheme: Coverage is provided to owners

of goods, whether buyer or seller, for damage or loss of goods
while in the process of delivery whether by land, air or sea.
448 chapter 8

• Houseowner's anil Householder's Takaful Scheme: Coverage is

provided fo owners and tenants who undertake coverage for
loss or damage of their household belongings and home (the
structure).

IMPLEMENTATION METHOD OF TAKAFUL

SYSTEM

There are several operational concepts which may be implemented

by takaful operators, for both family lakaful and general takaful.
The concept selected by an operator would depend on the Syariah
principle it intends to apply. This section will only discuss the
implementation method of the takaful system found in Malaysia.
The discussion will include methods practised by Syarikat Takaful
Malaysia, Etiqa Takaful and Takaful Ikhlas. The implementation
methods of general takaful will be presented, followed by those of
family takaful.

Implementation of General Takaful

General lakaful involves coverage for properties. This facility
is offered by all takaful operators in Malaysia. However, slight
variations exist in the method of implementation. For instance.
Syarikat Takaful Malaysia uses the mudharabah and tabarru principles
in its operation of general takaful. Depending on the scheme taken
up, the participant would contribute an amount of money in
accordance with the terms involved and sign a mutual agreement
of mudharabah with the company. At the same time, the participant
agrees to donate a portion of his money to other participants who
are hit by disasters. The flow of general takaful operations is as
shown in Figure 8-1.
 ISLAMIC INSURANCE SYSTEM 449

FIGURE 8-1 Method of Operation of General Takaful, Syarikat

Takaful Malaysia

As shown in Figure 8-1, all of the participants' contributions

would be put in the General Takaful Fund. The money in the fund
would be invested by the company, and the profit attained would
be placed back into the fund. At the end of the stipulated period,
surplus or profit from the fund would be distributed back to the
participants. Before distribution, deductions would first be made
for matters such as payment of claims, retakaful and reserves.
Tlie company would not impose any fee for management, but would
instead receive its share through profit-sharing of the surplus made
from the investments.
The principles used by Etiqa Takaful in the operations of general
takaful are tabarru, wakalah and mudharabah. The tabarru principle
is used when participants agree to mutually help one another.
The wakalah principle is applied between the participants and the
operator, that is, Etiqa Takaful, whereby the company receives
payment for the tasks performed. The mudharabah principle applied
between the participants and the operator entails an agreement on
the part of the participants to share the profit on anv surplus from
the fund which is past its term but is not yet collected by participants
450 CHATTER 8

An example of the mudlutrabah text placed in the certificate is as

follows:

If after the expiry of the takaful there is net surplus from Ihe General
Takaful Fund, it will he shared between the participant and the
company in the ratio of 50:50 provided that the participant had not
submitted any claims or received any benefits during the period that
the takaful was in force.

The operation flow of the general takaful scheme of Etiqa Takaful

Berhad is illustrated in Figure 8-2.

FIGURE 8-2 Method of Operation of General Takaful,

Etiqa Takaful

Figure 8-2 shows that participants' contributions arc deposited

into the General Takaful Fund: at the same time the company
imposes a service charge on the participants. The money from
the fund is invested by the company. As with Syarikat Takaful
Malaysia, the profit is added to the fund and the accumulated fund
is then used for payments such as payment on claims and retakaful.
Sharing of profits is based on the agreed ratio and made on the
underwriting surplus and investment income.
The operational flow of Takaful Ikhlas differs slightly from that
of Etiqa Takaful as shown in Figure 8-3. (Etiqa Takaful imposes a
 ISLAMIC INSURANCE SYS1 EM 451

service charge at the initial stage, that is when the participant starts
to pay premium.)

FIGURE 8-3 Method of Operation of General Takaful,

Takaful Ikhlas

Figure 8-3 shows that participants contribute to the General Risk

Investment Account (GRIA). The GRIA is divided into two types
of funds, namely Ta'awuni Account Pool and Investment Fund.
The Ta'awuni Account Pool ftawaani means collaboration or
cooperation) is subdivided into three types of accounts or funds,
Expenses Account, Risk Account and Special Account. Expenses
Account contains front-end and back-end charges imposed on
participants. Front-end charges are fees charged at the time of
the initial purchase of the policy or contract renewal and are
commissions paid to agents or representatives. Back-end charges
are payments imposed on participants such as claims processing
charges, policy renewal charges and fees for other transactions. Risk
Account is based on the tabarni principle and is used for mutual
coverage of participants. Payment into this account is based on a
one-year coverage, retakaful charges and reserves. Any surplus in
this account will be allocated to the GRIA. This special account is
also founded on the tabarru concept and its purpose is to function as
452 CHATTER 8

a supporting fund to the Risk Account and to provide coverage for

participants. If funds in this account are insufficient to compensate
or indemnify participants, the company (shareholders) will issue a
loan to subsidize the deficit.
Funds in the investment account would also be invested by the
company. If there is any surplus or profit, the company will impose
a service charge and the surplus will be deposited back into the
GRIA.

Implementation of Family Takaful

There are three main objectives held by those who participate in
the family takaful scheme. First, to provide financial coverage for
their beneficiaries in the event of premature death. Secondly, to
have a form of savings for future use or for old age. Thirdly, to
be financially prepared in the case of an accident which results in
long-term disability or in the case of a chronic disease. Thus, the
takaful operator will normally offer a scheme which provides cover
to achieve such objectives. Although family takaful is divided into
two major categories, namely family takaful and group family
takaful, the discussion here is limited to the implementation of
family takaful.
Participants who undertake family taka/id coverage with Syarikat
Takaful Malaysia make a contribution, which is credited into the
Participant’s Account (PA) and Participant's Special Account (PSA).
Tlie operation flow of the family takaful offered by Syarikat Takaful
Malaysia is shown in Figure 8—f.
 ISLAMIC 1NSIRANCE SLSI1 M 453

FIGURE 8-4 Implementation of Family Takaful, Syarikat Takaful

Malaysia

As can be seen from Figure 8-4, funds accumulated in the I’A and
PSA will be invested by the company based on the principle of
mudharabah. The profit obtained will then be shared according to
the ratio agreed at the beginning of the contract. The PA is treated
in accordance with the principle of mudharabah whereas the PSA is
treated on the basis of tabarru. The participants' share of profit will
be credited into the related account. Profit from investment of the PA
and PSA will be credited into their respective accounts. The surplus
from both accounts will be repaid accordingly to the participants.
In the event of the premature death of a participant, beneficiaries
are entitled to claim the policy value from the PA fund as well as the
accumulated amount from the PSA. On the other hand, if there is
no claim made during the policy period, the participant can claim
from the PA fund along with any surplus allocated to him in his
PSA. If the participant withdraws before the maturity date of the
policy, he can only claim the balance in his PA fund.
The operation concept of Etiqa Takaful does not differ much
from that of Syarikat Takaful Malaysia. Participants' contribution is
454 CHArrt'R8

also credited into the PA and PSA. The PA has elements of savings
while the PSA is maintained based on the tabarru concept. However,
there is a slight difference with respect to allocation of profit. While
Syarikat Takaful Malaysia apportions profit based on gross profit,
that is returns from investments, Etiqa Takaful imposes a service
charge on profit acquired from investments using PSA funds.
Distribution of profit will only be done after the service charge has
been made to the operator.
Takaful Ikhlas, on the other hand, models its takaful business on
the wakalah concept whereby the participants appoint it to manage
all aspects of the takaful business transactions. As with other takaful
operators, participants' contribution for mutual coverage against
disasters is conducted through the tabarru concept. Equally, the
family takaful product provided by Takaful Ikhlas is classified into
two groups, namely coverage with savings and savings alone.
There is not much difference between these two types of coverage,
except that participants' contribution for coverage with savings is
deposited into the Personal Investment Account, while participants
who choose the scheme for coverage alone would have their
contributions credited into the Personal Risk Investment Account.
The operation of the Takaful Ikhlas scheme with savings is shown
in Figure 8-5.

FIGURE 8-5 Operation Method of Family Takaful,

Takaful Ikhlas
 ISLAMIC USSUHAlSCt SYSTTM 455

As can be seen from Figure 8-5, participants' contribution is

placed in the Personal Investment Account. Tire funds collected
are then apportioned into two accounts, the Ta'awuni Account
and tlte Investment Account. The Ta'awuni Account is further split
into three. Expenses Account, Risk Account and Special Account.
Expenses Account consists of service charges collected by the
company for the operation of the hikiifiil business. Risk Account
consists of donations rendered for mutual coverage and Special
Account is set up to subsidize deficits in the Risk Account. The total
amount of deposits made by participants in the investment fund
will be invested by the company and the profit obtained will be
subjected to management fees or charges. The surplus would be
channelled into the participants' Personal Investment Account.
Similarly with the participants' Risk Account, any surplus in
this account would also be invested. The profit obtained would
be subjected to management fees or charges and the surplus will
be allocated to the Personal Investment Account. Payment to
participants would be made either at maturity or when a participant
is faced with a mishap. Payment issued at maturity is done by using
the participant's savings in his personal account and profit in the
Risk Account. Payment before maturity as a result of a mishap is
done by using the participant's savings in the Personal Investment
Account and surplus in the Risk Account.

SUMMARY

Tire insurance system came into existence due to the natural desire
of humans to help one another in their community. The history of
insurance began around 3000 BC when Chinese traders practised
risk-sharing techniques in transporting their goods when travelling
across treacherous water. Apart from that, during 2500 BC the
Egyptians also practised a system of mutual assistance. 1 lelp was
456 CHAPTER 8

rendered in the event that any member of their community faced

difficulty as a result of death or financing the high cost of medical
treatment. The Code of Hammurabi introduced in 1800 BC outlined
the aspects of compensation to those who suffered losses as a result
of disasters.
The 13th century saw the beginning of modem insurance when
marine insurance was introduced in Italy, followed by life insurance
in 1536. Fire insurance was introduced in 1591 in Germany, and
the Great Fire of London of 1666 was said to have opened the eyes
of the people in Britain to the need for such an insurance cover.
Insurance coverage for accidents started in 1848 when a company
sold insurance cover to train passengers. No precise information
is available as to when insurance was first introduced in Malaysia.
However, the development of the tin and rubber industry during
the late 1980s and early 1900s was said to be the early period of the
insurance system in the country. By the end of 2007, as many as 126
insurance licences had been issued to companies operating in the
conventional insurance system in Malaysia.
However, features associated with conventional insurance
are incompatible with Islamic principles. According to the
ulama, conventional insurance does not conform to the rules and
requirements of Syariah as it embodies three main elements, namely
gharar (uncertainty), maisir (gambling) and riba (interest) which
are prohibited in Islam. Since Muslims are also subject to possible
disasters, a suitable system to cover them from unexpected disasters
and catastrophes is essential. The demand for Islam to have its
own insurance system became even more pressing when Islamic
banks were established throughout the world simply because Ute
banks needed to have some form of cover for the risk associated
with unpaid financing. Consequently, most Islamic banks are
shareholders of takaful companies. For instance, Syarikat Takaful
was established by Bank Islam Malaysia Berhad.
Islamic insurance, or better known as takaful, had its beginnings
in the early years of Islam under the aqtla system. The modern takaful
 ISLAMIC INSURANCE SYSTEM -157

system began in 1979 when a takaful company started its operations

in Sudan. In Malaysia, the takaful system was introduced in 1984
with the establishment of Syarikat Takaful Malaysia. Today, besides
Syarikat Takaful Malaysia, there are seven other takaful companies
operating in Malaysia. The concepts used by these companies in
their operations are not uniform. Some use the mudharabah and
tabarru concepts while others use the wakalah concept. As with
the development of the Islamic banking system, the progress and
rapidity of the development of the takaful system in Malaysia is to
a large extent influenced by government involvement. Compared
to other Islamic countries, the Malaysian government is highly
committed to the advancement of the takaful industry. Through
Bank Negara Malaysia, detailed and well-organized plans have
been made towards making the domestic takaful industry a
reputable and exemplar}’ model for other countries. Although the
takaful industry is still in its infancy compared to the conventional
industry, it now offers products similar to those of the conventional
insurance system.

REFERENCES AND FURTHER READING

Abu Bakar, Md Azmi Abu Bakar. The Development of Takaful in the

Global Perspectives. Working paper presented at the seminar
Takaful for Non-Takaful Practitioners, Islamic Banking and
Finance Institute Malaysia, Kuala Lumpur, 19-20 July 2004.

AJ-Khattab, Nasiruddin. Sunan Ibn Ma/ah. Beirut (Lebanon):

Darussalam, 2007.

Badan Petugas Penubuhan Syarikat Insurans Secara Islam Di

Malaysia. Laporan Penubuhan Syarikat Takaful, Prime Minister's
Office, Kuala Lumpur. 1984.
458 CHATTERS

Bank Islam Research and Training Institute. Takaful (Islamic

Insurance), Concept & Operational System. Kuala Lumpur: BIMB
Research and Training Institute, 1996.

Bank Negara Malaysia. Annual Report 1989.

Bank Negara Malaysia- Annual Report 2001.

Bank Negara Malaysia. Annual Insurance Statistics 2007(a).

Bank Negara Malaysia. Annual Takaful Statistics 2007(b).

Barnhart Robert K. The Barnhart Dictionary of Etymology. USA: The

H.W. Wilson Company, 1988.

Muslehuddin, Muhammad. Insurance and Islamic Law. New Delhi

(India): Markazi Maktaba Islami, 1982.

New Encyclopedia Britannica, The. Vol. 9. Chicago (Illinois. USA):

Encyclopedia Britannica Inc., 1983.

Oxford English Dictionary, The. 2nd ed. Vol. VII. Oxford: Clarendon
Press, 1991.

Vaughan. Emmet J. and Therese Vaughan. Fundamentals of Risk and

Insurance. Sth ed. New York (USA): John Wiley & Sons. 1999.

www.maybank2u.com.my

www.takaful-ikhlas.com.my

www.takaful-malaysia.com.mv

www.takafulnasional.com.my

Yasir Qadhi, Abu Ammar. Suuan Abu Dawood. Beirut (Lebanon):

Darussalam, 2008.

Yusuf, Mohd Fadzli. Takaful Sistem Insurant Islam. Kuala Lumpur:

Utusan Publications & Distributors Sdn Bhd, 1996.
 CHAPTER

ORGANIZATIONS RELATED TO
THE ISLAMIC BANKING SYSTEM

This chapter discusses the role anil development ofimportant organizations

related to the Islamic banking system. The organizations and associations
that will be described encompass those which provide general or specific
services in particular aspects to Islamic financial institutions throughout
the world and, in some cases, to selected countries.

INTRODUCTION
There were two major organizations which played a significant
role in the early phase of modem Islamic banking system in most
Muslim countries. They were the Islamic Development Bank (IDB)
and the International Association of Islamic Banks (IAIB).
IDB and IAIB were established as a result of resolutions made
at the Second Islamic Conference of Foreign Ministers of the
Organization of Islamic Conference (OIC) in Karachi, Pakistan
in December 1970. The Foreign Ministers expressed the view
460 CHATTER 9

that a study should be conducted towards the establishment of

an international Islamic trading and development bank as well
as the establishment of a federation of Islamic banks. The task of
conducting the study was assigned to a panel of experts from 18
Muslim countries who in their report recommended that a financial
institution based on a participation scheme be established. The
panel further proposed three types of institutions.
The first type of institution proposed was an international
Islamic bank. Its functions were to include:

• Financing the intra-trade activities among Muslim countries.

• Providing funding to development and investment

institutions.

• Being responsible for the transfer, settlement or resolution of

conflict between the central institution and Islamic banks in
Muslim countries. This task was to be the beginning towards an
integrated Islamic economic system.

• Establishing central institutions in Muslim countries. These

institutions would offer short-term and long-term financing for
trading and developmental needs of associated countries.
• Supporting the efforts of the central institutions in Muslim
countries in achieving their objectives within the framework
allowed by Islam.

• Administering and utilizing zakat money

• Managing the surplus funds of central institutions

The second institution proposed was a specialized agency to be

called Investment and Development Body of Islamic Countries.
The functions of the agency were to include the following:

• To undertake investments of the financial capital on behalf of

Muslim countries.
 ORGANIZATIONS RELATED TO THE ISLAMIC HANKING SYSTEM 461

• To harmonize investment projects and development projects of

Muslim countries.

• To identify suitable areas for inyestment and conduct studies in

those areas.

• To offer advisory service and technical assistance on projects

assigned as regional investment in Muslim countries.

The third institution proposed was the Association of Islamic Banks

which was to act as a consultative body in the area of Islamic banking
and economy. This association was supposed to be responsible for
providing technical advice and assistance to countries wishing to
set up their own Islamic banks. Apart from assigning experts to
these Muslim countries, the association was expected to disseminate
knowledge related to Islamic banking and finance. It was also to act
as a liaison body in the exchange of knowledge and experience in
the field of Islamic banking among the member countries.
The proposal forwarded by the panel of experts were not
immediately accepted by the Foreign Ministers. Instead, at the third
conference in March 1973 in Libya, the Foreign Ministers decided
to review the proposal. In addition, the ministers decided to set up
the Department of Economy and Finance at the OIC Secretariat for
the purpose of conducting studies and providing advice in the area
of economy, particularly on the establishment of Islamic banks.
The task of reviewing and formulating the draft constitution, laws
and regulations related to the establishment of Islamic banks was
undertaken by a group of experts from oil producing countries
which were approved by the Foreign Ministers of OIC in August
1974 in Jeddah, Saudi Arabia. The establishment of IDB became a
reality in October 1975, with its headquarters in Jeddah.
Unlike IDB whose establishment was sponsored by Muslim
countries, the establishment of the International Association of
Islamic Banks (IAIB) was a private initiative. It was Saudi Prince
Mohamed al-Faisal al-Saud who provided the impetus for the
462 CHATTER 9

establishment of this association, in addition to being the main

motivator in the setting up of Islamic banks in most Muslim
countries. The establishment of this association became a reality on
20 August 1977 with Prince Mohamed al-Faisal as the chairman.
In the same year, the association received recognition at the
ninth Islamic Conference of Foreign Ministers of the OIC and
was bestowed the OIC observer status. Until 1997, IAIB played a
leading role in undertaking and facilitating research and
development activities in Islamic banking. The following were
among the objectives of the association:

• To promote the concept, philosophy and principles of Islamic

banking.

• To reconcile conceptual and operational problems as well as

standardize both the operational and application aspects of
Syariah.

• To create areas of cooperation among members.

• To provide assistance in human capital development.

• To encourage the establishment of Islamic banks and to provide

technical assistance and expertise.

• To represent, mediate and act as arbiter for and between Islamic

banks.

• To coordinate exchange of data among Islamic banks and

maintain a databank of all Islamic financial institutions.

• To develop Islamic inter-bank markets and to promote the flow

of funds between Islamic banks.

To achieve the above objectives, the organizational structure of IAIB

was categorized into four main bodies, namely General Secretariat,
Syariah Board, General Assembly and Board of Directors. The
General Assembly consisted of one representative from each
member and this body appointed members of the Board of
 ORGANIZATION'S Rtl-ATCD TO Tilt IS1 AMIC BANKING SI S 11 M 463

Directors. The General Secretariat administered the daily functions

of 1A1B, and was headed by the Secretary General. Meanwhile,
the functions of members were monitored by the Syariah Board.
Members of this Board compriseci heads of Syariah Boards of
Islamic banks which were members of the association, as well as
Muslim jurists who were members by invitation. This Board was
also responsible for supervising and regulating the operations
of members to ensure that they did not deviate from Syariah.
The Board also formulated fatwa and directives to be adhered to by
members. Although the objectives of the association were noble and
it brought benefits to the Islamic banking industry as well as the
Muslim ummah as a whole, this initiative was dissolved in 1997.
Its successor, the General Council of Islamic Banks and
Financial Institutions was established in Bahrain. This was
followed by the formation of other associations to promote the
establishment of a sound Islamic banking system. These associations
consist of the Islamic Financial Services Board centred in
Kuala Lumpur and the International Islamic Financial Market
centred in Bahrain. In Malaysia, an organization known as
the Association of Islamic Banking Institution Malaysia has been
set up to promote and represent the common interest of its
members who are financial institutions offering Islamic financial
products and services. In the education sector, the Institute of
Islamic Banking and Finance Malaysia was created to promote
education and training in Islamic banking.

ISLAMIC DEVELOPMENT BANK

The Islamic Development Bank (IDB) was officially inaugurated on

15 Syawal 1395 Hijrah corresponding to 20 October 1975, with its
headquarters in Jeddah, Saudi Arabia. The principal establishment
of IDB may be likened to that of the World Bank. However, the
464 CHATTER 9

establishment of IDB is to provide assistance to Muslim countries

(almost all Muslim countries are IDB shareholders) and its assistance
is based on the Si/ariah principles. Among the objectives for the
establishment of IDB is to foster economic development and social
progress of group members as well as reinforce the cooperative
relationship among OIC member countries. This bank is also
responsible for the mobilization of financial resources in existing
member countries or between member countries. In addition, it has
been envisaged that IDB will have the capacity to raise the level
of savings and investment as well as increase the inflow of funds
for developmental purpose in member countries. These objectives
were formulated with the aspiration that the economic development
and social advancement of member countries could be fostered
in conformity with Syarmh principles. Some of the functions of
IDB are:

• To participate in equity capital for productive projects and

enterprises in member countries.

• To undertake investments either in the form of equity

participation or other methods of financing for infrastructure
development in member countries.

• To provide financing to private parties or tire public for the

implementation of projects, enterprises or other programmes in
member countries.

• To establish and operate special funds for specific purposes.

• To set up and manage trust funds.

• To accept deposits and mobilize funds through Syariah

compatible modes.

■ To assist in the promotion of trade among members particularly

in capital goods.

• To appropriately invest surplus funds which arc not needed in

its operations.
 ORGANIZATIONS RELATED IO IHE ISLAMIC HANKING SYSTEM 465

• To provide technical assistance to member countries.

• To provide training facilities to personnel involved in

development activities in memljer countries.

• To conduct research and development in Islamic economics,

banking and finance.

• To enhance economic cooperation and coordination among

member countries in collaboration with development partners.

• To carry out other activities that can assist in meeting its

objectives.

• To operate in accordance with the principles of Syariah.

In its 2007-2008 annual report, these functions were summarized

as follows (Islamic Development Bank, Annual Report, 2007-2008,
Appendix VI):

The main function of IDB is to provide various forms of development

assistance for poverty alleviation through human development,
forgoing economic cooperation by promoting trade and investment
among member countries, and enhancing the role ofIslamicfinance in
the social and economic development ofmember countries. It establishes
special funds for specific purposes including a fund for assistance to
Muslim communities in non-member countries, in addition to setting
up trust funds.

In addition, IDB mobilizes financial resources using Shari'ah-

compliant modes and provides technical assistance to member
countries, including provision of training facilities for personnel
engaged in development activities in member countries.

In the early part of its establishment, the bank had only 22 members,
but its membership had increased to 47 by the end of 1994. As at
end of 2008, the number of members had increased to 56. One of the
main prerequisites for membership is that the prospective member
country must be a member of the OIC and must be willing to
466 CHAl'llK 9

accept the terms stipulated by the IDB Board of Governors, In the

early part of its establishment, the authorized capital for the bank
was Islamic dinar (ID) six thousand million. Islamic dinar is the
accounting unit used by IDB, where one unit of ID is equivalent to
one unit of Special Drawing Rights of the International Monetary
Fund. In 2007, total authorized capital was ID30 billion, and the
subscribed capital was 1D15 billion. Members' funds increased to
ID5.3 billion and paid-up capital increased by 9.1% toID3.07million.
Other components of members' funds were ID22.7 million in capital
reserve, ID1.523.9 million in general reserve and ID538.1 million in
fair value reserve as at end of 2007.
The bank's headquarters is located in Jeddah, Saudi Arabia
while two of its regional offices, one in Rabat, Morocco, and the
other in Kuala Lumpur, were opened in 1994 and 1995. respectively.
In 1997, IDB opened a representative office in Almaty, Kazakhstan
which serves as a link between IDB member countries and the
Central Asian Republics. The fourth regional office was established
in Dakar, Senegal in 2007. In addition, the bank also has field
representatives in 14 member countries, namely Indonesia, Iran.
Uzbekistan. Libya, Pakistan, Senegal Sudan, Sierra Leone, Guinea.
Guinea Bissau, Mauritania, Nigeria, Bangladesh and Azerbaijan.
The official language of the bank is Arabic, though English and
French are also used as supplementary working languages. Apart
from the capital funds contributed by its members, IDB also receives
financial resources in other forms to finance its operations. These
financial resources are normally derived from financing activities,
shareholding in companies and the placement of liquid cash in
commodity trading. Further, the recording and presentation of the
funds' financial statement are not consolidated into IDB’s financial
statement. There are also schemes in which IDB acts as ntliilarib or
entrepreneur, undertaking trade ventures using funds from other
parties and imposing operational fees on these ventures.
In order to supplement its subscribed capital, IDB has developed
several Syarm/i-compatible schemes and financial instruments.
 ORGANIZATIONS RELATED IO I >11 ISLAMIC RANKING SYSTEM 467

These include the Investment Deposit Scheme, 1DB Unit Investment

Fund, Islamic Banks' Portfolio for Investment and Development,
Export Financing Scheme, BADEA Export Financing Scheme and
Special Assistance Grants. (BADEA is the Arab Bank for Economic
Development in Africa.)
The Investment Deposit Scheme which was first introduced
in 1980 is a short-term investment facility provided to investors
participating in foreign trade financing operations. The mode
of financing used is based on the munibahah principle. Deposits
accepted are only those in the form of the Islamic dinar, American
dollar and Saudi riyal currencies. At the end of 2007, the fund raised
from tile scheme during the year was ID35.3 million. It was used to
finance operations under the 1DB general murabahab financing.
The Special Assistance Grants scheme was introduced in early
1998 in pursuant to the Board of Governors' Resolution BGI3-1417.
Through this resolution, funds amounting to ID1 billion were
created which included the transfer of assets of the former Special
Assistance Account established by IDB. With the establishment of
the Waqf Fund, all assets and liabilities of the Special Assistance
Account created in 1979 were consolidated into this new fund
including the three activities which were formerly under the Special
Assistance Account, namely Special Assistance, Special Account
for Least Developed Member Countries and Special Reserve.
The Special Reserve Account was replaced by the Waqf Fund.
At the end of the 2007 financial year, the net funds accumulated
totalled ID939.9 million, made up of US$79.8 million in the Special
Assistance Account, US$230.7 million in the Special Account for
Least Developed Member Countries and US$1,195.7 million in the
Waqf Fund.
In addition to the funds above, IDB set up other funds called
IDB Infrastructure Fund and Awqaf Properties Investment Fund
(AI’IF). Funds accumulated either through share capital contributed
by members or through special schemes, are utilized by IDB to
implement activities in accordance with its establishment goals.
4b8 ciiArrEK9

The activities conducted by the bank may be categorized into three

main groups, namely:

(i) Project financing, technical assistance and u-aqffund operations

(Special Assistance)

(ii) Trade financing operations

(iii) Specialized fund and affiliated institutions

Project Financing, Technical Assistance and Waqf Fund

Operations (Special Assistance)
Originally the method of financing used by IDB was simply based
on loans issued by way of holding equities in the projects concerned.
Nevertheless, the bank's method of financing has expanded over
the years to include leasing which was introduced in 1977, profit
sharing in 1978, instalment sales in 1985 and istisna in March 1996
Apart from direct financing, IDB also channels its financing
through the National Development Financing Institutions (NDFI)
which provides funding to small and medium-sized enterprises as
well as to the private and public sectors. As with direct financing,
the facilities channelled through NDFI also take the form of leasing,
instalment sales or istisnu or a combination of these methods.
This type of financing is referred to as line of financing.
Technical assistance financing provided by IDB is closely
related to project financing and aims to assist member countries
identify potential projects. The assistance includes provision for the
preparation of feasibility studies, detailed design and engineering
works, provision for consultancy services and preparation of
tender documents. Further, assistance is rendered in tire provision
of research and training equipment. IDB also helps to conduct
sectoral studies and monitor projects being implemented. Priority
for such technical assistance is given to the least developed member
countries.
 ORGANIZATIONS RELATED IO Illi ISLAMIC RANKING SYSTEM 469

The waijf concept refers to provision of aid to those in need.

The Waqf Fund was established in 1979 to provide aid to Muslim
communities in non-member countries with emphasis on education
and health. The fund also aims 'at alleviating the suffering of
Muslims in member and non-member countries who have been
badly affected by natural disasters such as droughts, floods and
earthquakes. The fund is also used to finance expenses of activities
which do not bring any profit to the bank. Currently, the income
generated from the Waqf Fund is used for social development
programmes such as financing the following activities:

• Special assistance programmes, particularly for Muslim

communities in non-IDB member countries.

• Islamic Research and Training Institute (IRTI).

• Scholarship programmes.

• Technical assistance programmes.

• International Centre for Biosaline Agirculture.

The total project financing and technical assistance provided by

IDB in the financial year 2007 and for the period from 1976 to 2007
are shown in Table 9-1.
Based on Table 9-1, total financing provided by IDB throughout
the financial year ending 2007 was about ID1,737.8 million
(US$2,663.6 million), which included 183 approved activities of
which 110 represented project financing and 73 were technical
assistance. Theoverall total project financing and technical assistance
(not including amortized financing) for the period 1976-2007 was
ID14.8 billion (US$20.6 billion), whereby 98,8"i. or ID14.7 billion
(US$20.4 billion) was for project financing with technical assistance
accounting for the remaining ID174 million (US$232.2 million).
Since 1976 till end of 2007, a total of 2,338 projects received financial
assistance from IDB of which 1,732 represented projects under
project financing, while 663 were technical assistance projects.
470 <H*rim9

TABLE 9-1 IDB Project Financing and Technical Assistance

(in ID million)

Type of 2007 1976-2007

financing No. Amount % No. Amount %

Project financing:

Loan 39 239.2 13.8 732 3/361.2 22.6

Equity 24 207.7 11.9 213 1,299.1 8.8

Leasing 22 623.9 35.9 330 4,473.6 30.1

Instalment sale 8 222.5 12.8 231 2,154.8 14.5

Profit-sharing,' 2 48.1 2.8 11 148.2 1.0

Musharaka

Istisna 12 288.1 16.6 126 2,339.5 15.8

Combined lines 3 97.5 5.6 32 351.8 2.4

of financing

Others 0 0 0 57 542.5 3.7

Subtotal 110 1,727 99.4 1.732 14,670.8 98.9

Technical 73 10.9 0.6 663 174.0 1.1

assistance

Grand total 183 1,737.9 100 2,395 14,844.8 100

Source: Islamic Development Bank, Annual Report, 2007-2008,

Notes:
(i) Total financing for the 1976-2007 period is not inclusive of financing
already amortized or cancelled.
(ii) Financing issued in 2007 includes financing through the Special
Account for Least Developed Member Countries.
(iii) "Others" refers to investment in suluL and in financial institutions.
 ORGANIZATIONS RELATED IO rill IMAMIC BANKING SYSTEM 471

Projects participated in by IDB encompass a range of seciors,

including social (education and health), agriculture, public
utilities, transport and communications, industry, mining and
Islamic financial services. The breakdown of projects for the
2007 financial year is as follows: 6 projects in the agriculture and
agro-industry, 7 projects in the industry and mining sector,
21 transport and communications projects, 24 projects related to
public utilities, 51 social services projects and 38 projects in the
financial services sector,
Table 9-2 shows the distribution of IDB funding according to
sectors for the year ending March 2007 as well as the period since
the establishment of IDB until 2007. Loans are normally issued
for projects which have socio-economic impact. Such projects
encompass infrastructure development, such as road transport,
ports, airports, irrigation, land development, schools, hospitals,
low-cost housing, rural development and others. The repayment
period for loans under the 1DB Ordinary Capital resources is from
15 to25 years with a grace period of 3 to7years. Total project financing
from this fund amounted to ID1.372 million (US$2,087 million) in
2007. The repayment period for loans from the Special Account
for Least Developed Member Countries is 25 to 30 years including
a grace period of 10 years. IDB imposes a service fee based on
actual expenses provided not exceeding 2.5% per year for ordinary
loans and 0.75% for loans under the Special Account for Least
developed Member Countries. The maximum loan amount from
the Ordinary Capital resources is US$10 million, while from the
Special Account for Least Developed Member Countries is between
US$0.5 million and US$3 million. However, in special cases the loan
extended to least developed member countries may be increased to
US$5 million.
472 ciiaitir 9

TABLE 9-2 Distribution According to Sectors: IDB Project

Financing and Technical Assistance (in ID million)

2007 1976-2007
Sector
No. Amount % No. Amount %
Agriculture and 6 30.2 22 329 1,176.6 103
agro-industry
Industry and 7 89.6 6.5 152 1331.0 10.7
mining
Transport and 21 407.1 29.7 332 2365.6 22.4
communications
Public utilities 24 463.2 33.8 334 3,432.8 29.9
Social services 51 226.9 16.5 567 2,385.8 20.8
Financial services 38 1553 11.3 300 678.6 5.9
Grand total 147 1,372.3 100 2,014 11,470.4 100

Source: Islamic Development Bank. Annual Report, 2007-2008.

Under equity financing, IDB also participates in the share capital of

new proposed or existing enterprises. This equity participation is
of two forms, that is, either direct equity holding (IDB undertakes
direct investment in the business organization concerned) or
through financing done via NDFI. Whichever method is chosen, the
investment made by IDB must not exceed one third of the project’s
total paid-up capital.
Leasing facility usually involves the purchase of capital
equipment or other fixed assets with IDB retaining the ownership
right of the leased assets thoughout the leasing period. The leasing
period may extend up to 20 years with a gestation period of up
to 5 years. This facility is usually provided to member countries
categorized as medium income and high income countries, Today,
the profit margin is set at 5.1% with the option for a floating rate.
 ORGANIZATIONS REIAIFD TO Till ISLAMIC HANKING SYSTEM 473

The maximum amount of financing provided through leasing is

ID80 million per project.
Under the instalment sale concept, IDB will purchase equipment
and resell them to clients at a higher price. The repayment period
extends up to 20 years. The main difference between this method
and leasing is that ownership of asset is transferred to the purchaser
on delivery. Meanwhile, in the case of leasing, ownership of asset
is transferred at the end of the leasing period. Here, IDB imposes
mark-up of 5.1%, and the maximum value of a sale is ID80 million.
The profit-sharing concept involves the pooling of funds
between two or more parties for the financing of a project, with
each party sharing the profit or loss according to a mutually agreed
contract. The istisna concept which was first introduced in 1998
refers to the method whereby the seller agrees to make available
or to sell to the purchaser a commodity of a specified type on an
agreed date. This mode of financing is used to promote and enhance
intra-trade among member countries, finance infrastructural
projects implemented by private sectors such as electric generators
and transformers and the like. Istisna is normally used when the
instalment sale mode of financing is not suitable. Similar to the
instalment sale, the repayment period extends up to 20 years with a
grace period of 5 years. The mark-up used is also similar to that in
instalment sale mode of financing, that is, 5.1%, and the maximum
amount of financing is ID80 million.
Financing through NDF1 is provided by IDB to encourage
the development of small- and medium-sized industries of the
private sector. The modes of financing adopted include instalment
sale, isfisna and leasing. This mode of financing was originally
extended directly to the NDFIs, but from 1999 it was extended to
the governments of the member countries who would then channel
it to the respective NDFIs. Loans extended to governments of the
member countries are limited to a ceiling of 1D7 million per project
and are given as interest-free loans. Nonetheless, beneficiary of the
loans must pay IDIi an administrative fee of not more than 2.5%
474 CHATTER 9

per annum. Repayment period is between 15 to 20 years inclusive

of a grace period of 3 to 7 years. However, softer conditions are
also provided for particular types of projects in least developed
member countries whereby repayment period may be extended up
to 30 years including a grace period of 10 years. A service fee for
administration expenses is set at a maximum of 0.75% per annum.
Technical assistance is provided by IDB for conducting
feasibility studies; the preparation of technical designs and tender
documents; preparation of sectoral plans, construction programme
and institutional support for capacity building as well as consultancy
services for the supervision of projects during their implementation
stage. Financing is in the form of a grant or an interest-free loan.
The maximum value of the grant is ID300.000 while the repayment
period for the interest-free loan must not exceed 16 years including
a grace period of 4 years with a sen ice fee not more than 1.5% per
annum. The grant issued is taken from the IDB Waqf Fund.
For financing of foreign trade, the nturabahalt concept is applied
where IDB purchases the requested commodity and then resells
it to the beneficiary. The maximum period for import financing
is 30 months while it is 120 months for export financing. For both
import and export financing, the mark-up calculation is based on
the 12-month LIBOR (London Inter-bank Offered Rate) quoted on
the LIBOR IO (Interest Only) page of Reuters (a global information
company) on the date of each disbursement, plus a gross spread.
This gross spread is subject to several factors such as risk, tenure,
commodity being financed and market conditions. A 30% rebate
of the gross spread is given for payments made on or before the
due dates.
As discussed earlier in this chapter, the Waqf Fund is used for
a variety of activities. Among the activities are special assistance
especially for Muslim communities in IDB non-member countries,
Islamic Research and Training Institutes, scholarship programmes,
technical cooperation programmes, special fund for least developed
countries, financing of technical assistance, free-of-charge financing
 ORGANIZATIONS RELATED to THE ISLAMIC BANKING SVSTTM 475

and the Adahi Project, The discussion that follows will only cover
the use of the Waqf Fund for the purpose of Special Assistance
Programme, Scholarship Programme, Technical Cooperation
Programme, OlC-Vaccine and Illiteracy Eradication Programme.
Special Assistance Programme was first introduced in 1979.
The primary goal is to promote socio-economic development
and the uplift of Muslim ummah in non-member countries.
Development is implemented specifically in the areas of education
and health. It also aims to alleviate the sufferings of communities
inflicted by disasters in both member and non-member countries.
When the fund was first introduced, IDB Board of Governors made
the resolution that this special assistance account may only be used
in the following areas:

(i) Training and research for member countries towards the

reorientation of their economic, finance and banking activities
in line with Syariah law;

(ii) Rehabilitation aid for victims of natural disasters and/or

conflicts;

(iii) Aid to member countries to expand and enhance the Islamic

syiar.

Ever since this programme was implemented, assistance

provided to Muslims in non-member countries had concentrated
on developing the socio-economic development of Muslim
communities, particularly in the education, social and health areas
including emergency and relief operations. In 2(X)7, IDB financed
62 special assistance projects worth US$25.7 million, of which
US$11.1 million was approved for 23 projects in member countries
and US$14.6 million for 39 projects in non-member countries.
The activities of the Special Assistance Programme received
funding from the IDB Waqf Fund. Since its launch, a total of 1,185
projects under the Special Assistance Programme worth US$640.8
million had been financed by IDB. Out of this amount, US$417.6
476 CHATTER 9

million was allocated for 465 operations in member countries and

US$232.2 million was approved for 729 projects in non-member
countries.
Die 1DB scholarship programme was introduced in 1983, and
up until 2007 IDB had introduced three types of scholarships as
follows:

• Scholarships for Muslim communities in non-member

countries.

• IDB merit scholarships for high technology.

• Masters of Science scholarships in science and technology for

the least developed member countries of IDB.

The Scholarship Programme for the Muslim communities in non-

member countries was launched in 1404 H (1983-1984). Its aim is to
provide educational opportunities to the academically meritorious
and financially needy Muslims from non-IDB member countries to
pursue undergraduate study in fields such as medicine, dentistry,
agriculture, management, business and others. The scholarships are
awarded as grants or interest-free loans (ipirii hassan) which students
are required to repay after graduation and gainful employment
to the VVaqf Fund set up by IDB. The repaid fund would then be
used to provide scholarships to other deserving students trom the
same communities. The total amount of scholarship awarded since
its inception and up until 2007 was US$67 million. A total of 7,877
scholarships had been given out up to 2007of which 5,237 recipients
had completed their studies and 2,640 are at various stages of their
studies. The bank has so far extended scholarships to 48 countries
including 10 member countries.
The Merit Scholarship Programme tor High Technology was
introduced in 1411 H (1991-1992) and implemented the year after.
This programme aims to develop technically qualified human
resources in IDB member countries and also to advance research
in science and technology. Some significant changes took place in
2003. Tlte number of yearly scholarships awarded was increased
 ORGANIZATIONS KI.IATTD TO TUT ISLAMIC BANKING SVST KM 477

from 20 to 35, and the recipients of the programme were broadened

to include scholars from institutions in emerging high technology
countries in Asia and other member countries. Furthermore, focus
was shifted purely to doctorate degrees. These scholarships are
usually awarded to doctoral candidates for a period of three years
and up to a year for post-doctoral candidates. From its establishment
until 2007, a total of US$15 million had been spent, involving
392 recipients from 254 institutions from 46 member countries.
The Masters of Science Scholarship Programme in Science and
Technology was launched in 1998 with the objective of assisting
the least developed member countries of IDB in the development
of human capital in the areas of science and technology. This
programme has offered scholarships to 19 of the least developed
member countries including Afghanistan, Benin, Burkina Faso,
Chad, Comoros, Djibouti,Gambia,Guinea. Guinea-Bissau, Maldives,
Mali, Mauritania, Mozambique, Niger, Sierra Leone, Somalia. logo.
Uganda and Yemen. A total of 205 scholarships worth US$1 million
have been awarded since its launch. Students have been placed
in various institutions in member countries such as Egypt, Mali,
Malaysia, Morocco, Pakistan, Senegal, Turkey and Uganda.
The Technical Cooperation Programme which was initiated in
1404 H (1983-1984) was established with the following objectives:

• To mobilize the technical capabilities of member countries by

promoting and enhancing collaboration among them.

• To promote cooperation and theexchangeof relevant experience,

information and technologies in line with the development need
of the member countries.

• To reduce delay in project implementation by lessening

managerial, technical and institutional constraints.

During 2007, 108 operations involving a total amount of

US$2.8 million were approved under this programme. The
programme entails three types of activities, namely recruitment
of experts, on-the-job training and seminars and workshops.
478 CHAPTER 9

To date, 1,510 operations worth US$33.7 million have been

approved whereby US$4.7 million was for recruitment of experts,
US$11.8 million was for on-the-job training activities and
US$17.2 million was for seminars and workshops. In December
1999, the Board of Executive Directors approved two technical
grants worth US$3.5 million and US$5.6 million respectively
for two special programmes, namely Eradication of Illiteracy in
The Islamic World, and Self-sufficiency in Human Vaccine
Production. The recipient countries of the illiteracy eradication
programme aid were Bangladesh, Chad, Djibouti, Gambia, Jordan,
Mauritania, Morocco, Sierra Leone, Sudan and Yemen. Meanwhile,
for the vaccine grant, aids were issued to Algeria, Egypt, Iran and
Tunisia.

Trade Financing Operations

Trade finance activity was one of the initial activities conducted
by IDB. The activity was conducted either through direct funding
from IDB's own funds or through special funds established by IDB.
Several trade financing schemes were implemented by IDB with
the names of the schemes based on the name of the fund financing
the scheme. In line with the goal to enhance trade financing
activities, IDB introduced the Two-Step Murabahah Financing.
Under this mode of financing. IDB acted in two ways. First, IDB
provided financing to financial institutions to finance its own trade
activity. Secondly, 1DB accepted the funds provided by the financial
institutions to finance its own trade operations. At the end of the
2007 financial year, the trade financing schemes that had been
implemented by IDB were as follows:

• Import Trade Financing Operations

• Export Financing Scheme
• Islamic Banks’ Portfolio for Investment and Development
• IDB Unit Investment Fund
 ORGANIZATIONS RELATED TO Till ISL AMIC BASKING SYSTEM 479

Tlie Import Trade Financing Operations (TTFO) scheme was

introduced in 1977. The funds for ITFO mainly come from IDB's
own resources and from the Two-Step Murabahah Financing
scheme. The ITFO scheme has the following goals:

• To finance the import financing needs of member countries.

• To promote and encourage intra-trade among member

countries.

• To supplement the activities of IDB by providing Syariah-

compliant trade financing.

The ITFO scheme normally provides short-term financing. The

method involves the purchasing of commodities and reselling
them against deferred payment (buy-nl-mnrnbaha) at cost price and
reasonable rate of profit to member countries. In 2006, a total of
67 operations worth US$2.6 billion were approved. Funds under
this scheme are generally extended for the import of commodities
such as crude oil and petroleum products, raw and chemical
materials, fertilizers, iron and steel items, spare parts, pulp paper
and natural rubber. From the date of its inception until 2006, ITFO
had approved 1,420 operations worth US$23,5 billion.
The Export Financing Scheme is a special fund established by
IDB under Article 22 of its Articles of Agreement. This fund was
originally established under the name "Long-term Trade Financing
Scheme" in 1985 with the objective of promoting the exports of
traditional and non-traditional commodities of member countries.
The scheme has its own membership, capital, resources and budget.
Its accounts are maintained separately. The scheme provides
financing to the non-conventional commodity exports of member
countries with a repayment period of between six months and
five years. For consumer commodities, the maximum repayment
period is 24 months. For the export of raw materials and capital
commodities, the maximum repayment period is three years
and five years, respectively. During 2006, a total of 17 operations
480 CHATTER 9

worth US$378.1 million were approved. Up until 2006, a total of

217 projects worth US$1.7 billion had been approved.
The BADEA Export Financing Scheme was the outcome of
a memorandum of understanding signed on 23 February 1998
between IDB and the Arab Bank for Economic Development in
Africa (BADEA) based in Khartoum. Sudan. BADEA has approved
an allocation of US$50 million to finance foreign trade between
the Arab and African countries. This funds are used specifically
to finance exports of Arab countries that are members of the Arab
League to African countries that are members of the Organization
of African Unity but do not belong to the Arab League. Between
1998 and 2006, the BADEA Export Financing Scheme extended
financing to 12 operations worth US$163.6 million. Out of this
amount, US$39.1 million was approved in 2003. Most of the funds
were used by African countries to import capital commodities from
Arab countries.
The Islamic Banks' Portfolio for Investment and Development
alsoallocatesa major portion of its funds to finance trading activities.
In 2006, a total of 8 projects worth US$202.8 million involving
Bangladesh, Lebanon, Egypt, Pakistan, Saudi Arabia, Tunisia and
Turkey were financed through this scheme. Up until 2006,186 trade
financing projects worth US$3,0.39.1 million had been approved.
IDB Unit Investment Fund also uses a portion of its resources
to finance trading activities either as direct financing or through
syndication. During 2007, one project valued at US$15 million was
approved, making it a total of 111 trade financing projects worth
US$921.3 million approved altogether.
The year 2006 was the last year IDB undertook trade financing
activities. In 2007, all trade related activities of IDB such as ITFO,
BADEA Scheme and Islamic Banks’ Portfolio for Investment and
Development were taken over by the International Islamic Trade
Finance Corporation (ITFC). The establishment of ITFC was
approved at the 30th meeting of the IDB Board of Governors in
lune 2005 and commenced operations in 2007. Among the main
 ORGANIZATIONS RELATED TO 1111 ISLAMIC RANKING SYSTEM 481

objectives of ITFC are to promote and finance intra-trade among

member countries and upgrade the export capabilities of member
countries.
Since the year 2000, other fund's of the bank have been used
to finance trade operations. The funds involved include Islamic
Corporation for the Development of the Private Sector, Awqaf
Properties Investment Fund and the Treasury Department
trade financing. Up to the end of 2007, sums of US$40.1 million,
US$51.3 million and US$548.7 million were disbursed through
Awqaf Properties Investment Fund, Islamic Corporation for the
Development of the Private Sector and the Treasury Department,
respectively. The number of projects under trade finance which
was approved by IDB in 2007 as well as the corresponding amount
approved since the implementation of these schemes, are shown in
Table 9-3.

TABLE 9-3 IDB Trade Finance Total

2007 Overall
Amount Amount
Type of scheme
No. (USS % No. (USS %
million) million)
Import Trade 67 2,602.5 99.4 1,420 23,512.3 80.7
Financing
Export Financing - - - 217 1,669.9 5.7
Islamic Banks’ - - * 186 3,039.1 10.4
Portfolio
Unit Investment 1 15 0.6 HI 921.3 3.2
Fund
Total 68 2,617.5 100 1,934 29,142.6

Source: Islamic Development Bank, Annual Report, 2007-2008.

482 <HArim9

Activities of Specialized Funds and Affiliated

Institutions
In line with its current development and challenges, IDB has
sought new methods or has coordinated its activities in line with
the changes that are taking place in the organization. Today, IDB
is a parent organization that has many corporate entities whose
legislation and financial operations are independent and separate
from IDB. The bank has also established many funds with the goal
of making itself the catalyst or mobilizer of resources that would
aid the bank in implementing additional tasks such as providing
training and conducting research related to Islamic finance and
banking. Among the entities and funds managed by IDB are:

• IDB Unit Investment Fund

• IDB Infrastructure Fund

• Islamic Solidarity Fund for Development

• Islamic Corporation for Insurance of Investments and Export

Credits

• Islamic Corporation for the Development of the Private Sector

• Islamic Research and Training Institute

• IDB Sacrificial Meat Utilization Project of the Kingdom of

Saudi Arabia - Adahi Project

• Awqaf Properties Investment Fund

• World Waqf Foundation

• International Centre for Biosaline Agriculture, Dubai

• Tlie OIC Networks Sdn Bhd, Malaysia

The 1DB Unit Investment Fund is a trust fund established in

December 1989 under Article 23 of the Articles of Agreement
 ORGANIZATIONS KI l.ATLP TO TUT ISLAMIC BANKING SVSTTM 483

of IDB. The aim of the fund is to participate in the economic

development of member countries through the pooling of savings
of institutional and individual investors. The fund is listed on the
Bahrain Stock Exchange. At the end 'of 2007, the initial issue which
was US$100 million was raised to US$325 million and held by
20 investors from 11 countries. These accumulated funds are
mobilized by way of direct financing, mutual financing and
syndicated financing. The financing principles used include
the murabahah, istisna, instalment sale, and resale and leasing
principles. Since its inception, the fund has financed 111 projects
worth US$921.3 million. At the 2007 Board of Executive Directors
meeting, the Board agreed to transfer the Unit Investment Fund to
IDB's member group, the Islamic Corporation for the Development
of the Private Sector.
The IDB Infrastructure Fund (IFF) was established in 1999 and
is based in Bahrain. The fund specifically focuses on infrastructure
development in IDB member countries. As such, funds are invested
in infrastructure projects and infrastructure-related industries
in member countries. As at end of 2007, this fund had invested
US$584 million in 11 projects covering nine member countries.
In May 2007, IDB launched the Islamic Solidarity Fund for
Development (ISFD) with the prime aim of alleviating poverty,
enhancing capacity building, eliminating illiteracy, and eradicating
diseases and epidemics in the organization's member countries. The
fund is established on the basis of voluntary contributions from all
member countries. The fund is in the form of waqf and commenced
operations in early 2008. IDB has contributed US$1 billion towards
the capital of the fund with another US$1.6 billion contributions
coming from its 30 member countries.
The Islamic Corporation for Insurance of Investments and
Export Credit (ICIEC) was established on 1 August 1994 and began
operations in July 1995 with an authorized capital of ID150 million
(US$240 million) which is made up of 150,000 shares of 101,000
each. IDB has subscribed US$160 million of the authorized capital
184 in Art i:k 9

while US$77 million is subscribed by the 37 OIC member countries.

The goals ot this Syariah-based organization are:

• To provide export credit insurance and re-insurance coverage

on non-payment export receivables from commercial and
non-commercial risks.

• To provide investment insurance and re-insurance against

country risk.

Between 1996 and January 2008, ICIEC's total business insured

was US$3.7 billion. During the 2006-2007 financial year, the total
number of policies issued was 75 with its current commitments
of US$1,467 million. For the same financial year, IClEC’s business
insured amounted to US$859 million.
The Islamic Corporation for the Development of the Private
Sector (IC'D) was established in November 1999 as an independent
international organization with an authorized capital of
US$1 billion. Out of this authorized capital, US$500 million has
been made available for subscription with IDB subscribing 50%.
member countries 30% and public financial institutions in member
countries 20%. The ICD provides a variety of financial products
including direct financing, asset management, structured financing
and advisor)' services. The corporation utilizes modes of financing
that are in accordance with Islamic concept of financing such
as equity participation and term financing such as murabahah,
leasing, instalment sale and istisna. Since its establishment, 1CD has
approved a total of 121 projects worth US$680.5 million. At the end
of 2007, 23 members had participated in this programme. The main
objectives of ICD are:

• To identify opportunities available in the private sector that

could function as engines of growth.

• To provide a wide range of Syariil/l-based financial products

and services.
 ORGANIZATIONS HI I A l 1 11 TO Tilt ISLAMIC BANKING STS! I M 485

• To encourage the development of and expand the access to the

Islamic capital market.

The Islamic Research and Training .Institute (1RT1) was established

in 1981 with the mandate to undertake research and training
activities in the areas of Islamic economics, finance and banking.
This institute also provides training facilities for the work force
involved in economic development activities in member countries.
The functions of the institute are as follows:

• To organize and conduct basic and applied research with the

aim of developing models and methods for the application of
Syariah in the areas of economics, finance and banking.

• To provide training and develop professionals in Islamic

economics in order to fulfil the research and training
requirements of Si/aria/i-observing institutions in member
countries.

• To train personnel in member countries who are involved in

development activities.

• To establish centres which collect, organize and disseminate

information that is related to its activities.

• To carry out activities that may be relevant or conducive to the

attainment of its purpose.

In 1982, the government of Saudi Arabia appointed IDB to manage its

project on the utilization of hajj meat. The prime goal of this project
is to assist pilgrims to fulfil one of the important rites of animal
sacrifice and at the same time to utilize and distribute the sacrificial
meat to the poor and needy Muslims in member and non-member
countries. In 2007 IDB slaughtered a total of 732,855 animals.
The sacrificial meat was distributed in Mecca and transported via
air, sea and land to several destinations in 27 countries.
486 CHAPTER 9

Awqaf Properties Investment Fund (APIF) was established in

pursuant to the decision made during the Sixth Awqaf Ministerial
Meeting held in Jakarta on 29 October 1997. The fund had an initial
subscribed capital of US$51 million and the capital base was increased
to US$59 million in 2007. Since its establishment, APIF has approved
28 projects worth US$529 million in Indonesia, Kuwait, Malaysia,
Saudi Arabia and the United Arab Emirates.
World Waqf Foundation was established in September 2001
(1422 H). IDB has contributed US$25 million to the foundation.
The minimum value for individual contribution is at least
US$1 million. The objectives of the foundation are:

• To further enhance IDB's efforts in the development of waqf

funds.

• To support waqf towards increasing the social and economic

development of Muslim communities and eradicating poverty.

• To fulfil the aspirations of welfare and philanthropic

organizations for the establishment of an international waqf
organization.

• To manage waqf properties entrusted to the foundation for

safe-keeping and investment, and spend the income in
accordance with the requirements of Si/ariah.

The International Centre for Biosaline Agriculture (1CBA) which is

based in Dubai commenced operations in June 1999. The objective of
ICBA is to develop irrigated agriculture technology that uses water
of moderate to high salinity. The centre is expected to develop plant
technologies that produce crops using various levels of saline water.
Since its establishment, IDB and other donors have contributed a
total of US$29.6 million for lCBA's activities. Throughout 2007, the
centre conducted three technical programmes; 21 production and
management systems programme; and 7 joint programmes under
the communication, networking and information management
 ORGANIZATIONS RELATED TO THE ISl.AMIl HANKING STSTEM 487

programme. The centre also held seven courses and four workshops
and seminars.
The O1C Information Systems Networks (OICIS-Net) is a project
which was initiated in pursuance of the Meeting of Heads of Islamic
Countries in Kuwait in 1987. The OICIS-NET is a joint venture
with IDB holding 51% of the shares in the company. The main
activities of this company are information services, e-commerce,
internet connectivity and consultancy services. This project aims to
improve the exchange and sharing of information resources among
the member countries. The pilot project took off in nine member
countries, namely Egypt, Indonesia, Kuwait. Malaysia, Morocco,
Oman, Pakistan, Senegal and Turkey. A range of components are
found in the information network, including network institution
development, data base development, systems and standards,
information service, telecommunications and training of personnel
in information and communication technology. In the endeavour
to develop this data base, priority has been given to the trade,
corporate and agriculture sectors.

ACCOUNTING AND AUDITING

ORGANIZATION FOR ISLAMIC
FINANCIAL INSTITUTIONS

The Accounting and Auditing Organization for Islamic Financial

Institutions (AAOIFI) is a non-profit organization established
in Bahrain on 1 Safar 1410 corresponding to 27 March 1991. This
organization, which was formerly known as Financial Accounting
Organization for Islamic Banksand Financial Institutions (FAO1BFI)
aims to develop accounting, auditing, governance, ethics and Syariah
standards for the Islamic financial institutions. The chief motivator
for the establishment was Dr. Rifaat Ahmed Abdel Karim. He was
488 CHATTER 9

also AAOIFTs first Secretary General. The current Secretary- General

is Dr. Mohamad Nedal Alchaar.
The AAOIFTs organizational structure consists of six divisions,
namely General Assembly, Board of Trustees, Accounting and
Auditing Standards Board, Syariah Board, Executive Committee
and Secretariat General. The General Assembly is the highest
authority. It is responsible for the formulation of policies of the
organization. Membership consists of four categories, namely
foundingmembers, associate members, regulatory and supervisory
authorities and observer members. Founding members include the
Islamic Development Bank (Saudi Arabia), Dar Al Mai Al Islami
(Switzerland), al-Rajhi Banking and Investment Corporation
(Saudi Arabia). Albaraka Banking (Bahrain), Kuwait Finance
House (Kuwait) and Bukhari Capital (Malaysia). At the end of
2008, AAOlFl's membership included more than 160 institutional
members from 40 countries.
The Board of Trustees consists of 20 part-time members
appointed by the General Assembly every five years. Members of
the Board remain in office until new members are appointed to
replace them. Appointment of members are based on geographical
location and from among the following:

• Regulatory and supervisory authorities

• Islamic financial institutions

• Accounting and auditing institutions related to Islamic financial

institutions

• Syariah fii/h scholars

• Users of financial statements of Islamic financial institutions

The trustees have the authority to appoint the AAOIFI board

members and terminate their membership in accordance with
statutory provisions, to arrange sources of finance for the
organization and invest these financial resources, to appoint two of
 ORGANIZATIONS RELATED IO T1IE ISLAMIC BANKING SYSTEM 489

its members to sit on the Executive Committee and to appoint the

Secretary General. Although the Board has wide ranging authority',
the trustees do not have the right or power to interfere in the other
boards of AAOIFI.
The AAOIFI's Accounting and Auditing Standards Board is
composed of 20 part-time members appointed by the Board of
Trustees for a five-year term. This Board meets at least twice a year.
Members are from among the following:

• Regulatory and supervisory authorities

• Islamic financial institutions

• Accounting and auditing institutions related to Islamic financial

institutions

• Syariah Supervisory Boards

• Users of financial statements of Islamic financial institutions

• University professors in the field of accounting and finance

• Certified accountants

The duties and responsibilities of the Board are as follows

(www.aaoifi.com/aasb):

• To prepare, adopt and interpret accounting, auditing and

regulatory statements, standards and guidelines for Islamic
financial institutions.

• To prepare and adopt code of ethics and educational standards

related to the activities of Islamic financial institutions.

• To review with the intention of making additions, deletions

or amendments to any accounting and auditing statements,
standards and guidelines prepared by the Accounting and
Auditing Standards Board. This is relevant to the enhancement
and development of the activities of Islamic financial
490 CHAITllK 9

institutions. Moreover, it is to fulfil the needs of the users of

financial statements of Islamic financial institutions.

• To prepare and adopt the due process for the preparation of

standards, regulations and by-laws of the Accounting and
Auditing Standards Board.

As with other boards, the Syariah Board consists of not more than
20 members each serving a four-year term. These Syariah experts
are representatives of the Syariah Supervisory Boards of the Islamic
financial institutions that are AAOIFI members, and the Syariah
members in the central banks. Among the roles and functions of
the Board are (www.aaoifi.com/sharia-board):

• To achieve harmonization and convergence in the concepts

and application of the fatwa issued by the Syariah Boards of
Islamic financial institutions in order to avoid contradiction or
inconsistency on the fatwa issued.

• To assist in the development of Syariah-approved instruments

and thus facilitating Islamic financial institutions in managing
developments in the areas of finance, investment and other
banking services.

• To study any enquiries raised by the Islamic financial institutions

to the Syariah Boards and to take action, either by giving Syariah
opinion on matters requiring collective i/tihad (reasoning), or
settling divergent points of view or acting as an arbitrator.

• To review and study standards issued by AAOIFI in accounting,

auditing, code of ethics and related statements to ensure that
they conform to Syariah regulations and principles.

The Executive Committee consists of six members, namely

the Secretary General, the Chairman of the Accounting and
Auditing Standards Board, the Chairman of the Syariah Board
and three members from the Board of Trustees. This committee
is charged with the responsibility of reviewing work plans.
 ORGANIZATIONS RELATED TO THE IS1 AMIC HANKING SYSTEM 491

annual budgets, financial statements and auditor's reports.

The committee also acts as the body that approves work and
finance regulations of AAOIFI. The Secretary General is the prime
pillar in the daily administration of the organization. He is tasked
with implementing the plan approved by both the Supervisory
Committee (the supreme authority of the organization) and by
the Financial Accounting Standards Board for Islamic Banks and
Financial Institutions.
Since its establishment, AAOIFI had put into operation three
major issuances, namely Accounting, Auditing and Regulatory
Standards for Islamic Financial Institutions, Syariah Standards, and
Statement on the Purpose and Calculation of the Capital Adequacy
Ratio for Islamic Banks (www.aaoifi.com). The organization has
also issued 68 standards in Islamic finance.

GENERAL COUNCIL FOR ISLAMIC BANKS

AND FINANCIAL INSTITUTIONS

Incorporated in Manama, Bahrain, the General Council for Islamic

Banks and Financial Institutions (CIBAFI) was established in
Mav 2001. Currently, most of its members are from the United
Arab Emirates, Kuwait and Malaysia. Membership of the council
is comprised of 130 Islamic banks and financial institutions from
40 countries including Islamic commercial banks, merchant banks
and financial institutions with Islamic window, Islamic funds and
takafid companies.
CIBAFI is an international non-profit organization with the
core mandate to enhance the image and ability of its members
to serve customers through the practice of ethical investment,
professionalism and transparency. This role is accomplished
through the following (www.cibafi.org):
492 ciurrtK 9

• Preparing a database or directory of banks and financial

institutions that comply with Islamic ethics.

• Participating in the development of Islamic banking and finance

by encouraging research and development and organizing
conferences in this area.

• Improving and promoting the understanding of Islamic finance

and banking and enhancing its existence locally and globally.

• Participating in the development of human resources by

providing its members training and consultancy services as
well as technical assistance.

The council comprises the General Assembly, Board of Directors.

Executive Committee and General Secretariat. Members of the
General Assembly consist of ordinary and observer members.
Meetings are held once a year to draft and decide on policies
or general specifications which are to be complied with and
implemented by the council. The Board of Directors, on the other
hand, decides on activities to be implemented by the council.
These activities would in turn be monitored and supervised by the
Executive Committee. The General Secretary', meanwhile, is the
principal manager of all activities planned.
To further strengthen its presence, the council is enhancing its
efforts to educate government personnel and the general public-
worldwide on the principles of Islamic banking. As an organization
that prepares and provides information, CIBAFI is actively involved
in publishing a number of research studies including Islamic
Finance in the Gulf Cooperation Council, Islamic Finance Directory
2007, CIBAFI Performance Indicators. Islamic Finance Directory
2006, Islamic Finance Directory 2005 and 1FSI First Global Report.
It also acts as a centre for conducting comparative studies related to
legislation and other fields. Presently. CIBAFI is working with the
Islamic Development Bank and Islamic Financial Services Board to
introduce a central Syariah council for issuing fatwa which would
 ORGANIZATIONS RELATED to THE ISLAMIC BANKING SYSTEM 4*>3

assist in dealing with different interpretations of Syarin/i-compliant

standards and practices between jurisdictions across the globe.

INTERNATIONAL ISLAMIC
FINANCIAL MARKET

The International Islamic Financial Market (IIFM) is a non-profit

organization which was established as a result of the effort initiated
by the Central Bank of Malaysia and Labuan Offshore Financial
Services Authority (LOFSA) which asserted the importance of
having an Islamic market to mobilize Islamic financial instruments.
This initiative proposed by Malaysia was collectively shared by a
number of countries as well as organizations including the Islamic
Development Bank, Central Bank of Bahrain, Bank Indonesia
(Indonesia's central bank). Bank of Sudan (Sudan's central bank)
and Brunei's Ministry of Finance. As a result, an agreement was
signed in Paris on 13 November 2001, whereby all the parties
involved recognized and acknowledged the shortcomings in the
Islamic financial system. Some of the shortcomings identified are:

• The absence of an international Islamic financial market.

• The lack of development of the Islamic capital market.

• Insufficient number of market participants and

Syririah-compliant financial instruments.

• The lack of uniformity' and consistency in Syariah interpretations

of ambiguous and doubtful issues.

• T he absence of a proper mechanism for the creation of an Islamic

financial market.

• The absence of global acceptance of the accounting standards

and practices of Islamic financial products.
494 CHATTER 9

• The absence of a secondary market for the transaction of

Sy«rin/i-compliant financial instruments.

To overcome the above shortcomings, the six founding members

agreed to set up a body with the vision of becoming a prominent
institution which promotes the active and well-regulated trading
of Islamic financial products and instruments internationally.
The mission of 1IFM is to promote the emergence and integration
of the Islamic financial market into a mainstream global market.
Initially, it was suggested that the organization be based in I.abuan,
Malaysia, but it was eventually incorporated in Bahrain on 1 April
2002. The Royal Decree for the establishment of this organization
was gazetted on 11 August 2002, followed by its registration on
25 November 2002. Among the objectives of this organization are
(www.iifm.net):

• To promote and enhance the development of international

financial markets in accordance with Syariah principles.

• To promote active participation of both Islamic and non-Islamic

financial institutions in the secondary market.

• To coordinate and act as a one-stop centre for Syariah

harmonization of interpretations and views in the global
financial market.

• To increase the framework of cooperation among Islamic

financial institutions all over the world.

• To issue market guidelines, best practices procedures and

assist in the formulation of standards for the Islamic financial
market.

Membership of IIFM totals 43 and is categorized into five groups,

namely founder member, full member, member, associate member
and observer member. Founder members are required to pay an
annual fee of US$35,000 and are the permanent members of the
Board of Directors. Full members comprise central banks and
 ORGANIZATIONS KI I AHO TO Hit ISLAMIC HANKING SYSTEM 195

monetary authorities, and full membership commands an annual

fee of US$25,000. Four board seats are reserved for full members.
The member category is given to Islamic financial institutions.
They are required to pay an annual'fee of US$20,000, and members
are allowed to fill five board seats. Associate members comprise
other financial institutions which are interested in Islamic financial
services and their annual fee is US$5,000. Meanwhile, the annual
fee for observer members is US$2,000. Both associate members and
observer members have no voting rights in the general meetings.
Although this organization has various functions, major
activities conducted currently cover only four areas, namely Syariah
endorsement, standardization and harmonization, market listing
and trading, and issuance of guides. In terms of its organizational
structure, IIFM consists of the Board of Directors (16), Syariah
Supervisory Advisory Panel (8), Executive Committee (7) and IIFM
Management.
In principle, the Board of Directors is responsible for policies
approval. The Board also has the authority to approve the admission
of new members and to appoint IIFM officers. The Syariah
Advisory Panel's responsibilities are to approve the application
and mechanism of transactions of a particular financial product
and instrument, to work closely with AAOIFI Syariah Board and to
provide guidelines for harmonization and uniformity in decision
making, and to review issues presented bv the Board of Directors
and the Executive Committee.
Since its establishment, IIFM has endorsed several global
financial instruments including the Malaysia Global Sukuk worth
US$600 million on 26 June 2002, Islamic Development Bank Sukuk
worth US$400 million on 3 August 2003, Qatar Global Sukuk worth
US$700 million on 8 September 2003 and Bahrain International
Sukuk worth US$250 million in 2004. In 2004, the organization
endorsed the US$100 million Tabreed Financial Corporation Sukuk.
The Malaysia Global Sukuk and Qatar Global Sukuk are based
on the ijarah concept, while Islamic Development Bank Sukuk is
496 CHATTER 9

based on the ijarah, murabahah and istisna concepts (www.iifm.net).

The global corporate sukuk issued by Tabreed Financial Corporation
is a combination of ijarah istisna and ijarah mawsufah Ji al dhimmah or
forward leasing contracts.
Following its relaunch in August 2006, IIFM has embarked
on a more focused and market-driven approach to position the
organization as a major player in the global Islamic banking and
finance industry. Thenew revised businessplan of IIFMplaces greater
emphasis on the standardization of Islamic financial instruments
and contracts, cross border trading and infrastructure development.
Previously, importance was placed more on Syariah endorsement
on the legality and permissibility of financial instruments issued
by financial institutions. Nonetheless, development of the global
primary and secondary capital market, development of a short-term
financial market and the creation of a market for Islamic financial
instruments still remain key areas for IIFM. In order to ensure that
standardized documents and products developed by IIFM are
accepted and adopted by Islamic financial institutions around the
world, the organization engages the industry and Syariah scholars in
discussions through several of its working groups. Working groups
that IIFM currently manages include Documentary Convergence
Working Group, 1IFM/ISDA Islamic Finance Working Group and
IIFM/ICMA Shariah Compliant Repo Core Working Group
In October 2008, IIFM launched the Master Agreement for
Treasury Placement (MATP) which is the first ever standardized
agreement for commodity murabahah transactions. The MATP
comprises a stand-alone Master Murabaha Agreement,
Master Agency Agreement and commodity purchase Letter
of Understanding. Prior to this, financial institutions had to
use 20 different documents when dealing with commodity
murabahah transactions. It is envisaged that the development of
such standardized agreement will translate into huge cost and
resource savings for financial institutions. Currently, IIFM is in
 ORGANIZATIONS RELATED TO THE ISLAMIC BANKING SYSTEM 497

the midst of finalizing two more standard documents, namely

the Master Agreement for Islamic Hedging (Ta'Ahut) and the
Syarm/i-compliant Repurchase Agreement (Repo). The former
document when completed shall be the standard document used
for privately negotiated Syari<i/i-compliant hedging transactions.
It is being jointly developed by IIFM and the International Swaps
and Derivatives Association (ISDA). The latter document is a
collaborative effort between I1FM and the International Capital
Market Association (ICMA) with main concentration on the
development of recommendations, standard documentations,
standard language and guidance for secondary market transactions
and standardized practices in trading of sukuk as well as other
Islamic financial instruments. IIFM and ICMA have also agreed to
develop the Global Master Repurchase (Repo) Agreement and a
handbook on the best practice recommendations for sukuk primary
issuance.

ISLAMIC FINANCIAL SERVICES BOARD

The Islamic Financial Services Board (IFSB) was established on

3 November 2002 and began operations in March 2003.
The Board was established in Malaysia under the Islamic Financial
Services Board Act 2002 which bestowed on IFSB the immunities
and privileges normally granted to international organizations
and diplomatic missions. This organization is similar to other
international standard-setting bodies which have vested interest
in the establishment and promotion of financial system best
practices, including the Basel Committee on Banking Supervision,
operating under the auspices of the Bank for International
Settlements, International Organization of Securities Commissions
and International Association of Insurance Supervisors. The goal
of IFSB is to be an organization that unifies financial authorities,
498 CIMl'Tf11 9

especially authorities in countries having Islamic banking systems,

in order to ensure the soundness and stability of the system.
Consequently, the critical task of IFSB is to issue standards,
guiding principles and technical notes for Islamic financial
institutions. There are three categories of membership, namely full
membership comprising supervisory authorities of each sovereign
country, associate membership comprising monetary authority' or
financial supervisory or regulatory organizations, and observer
membership comprising Islamic financial institutions throughout
the world. In 2008, there were 21 full members, 21 associate members
and 136 observer members (www.ifsb.org).
Since its establishment, IFSB has published seven prudential
standards and guiding principles for the Islamic financial services
industry as follows (www.iifm.net):

• Capital Adequacy' Requirement for Sukuk Securitisation and

Real Estate Investment.

• Guiding Principles on Governance for Islamic Collective

Investment Scheme.

• IFSB-5: Guidance on Key Elements in the Supervisory Review

Process of Institutions Offering Islamic Financial Services
(excluding Islamic Insurance (Takaful) Institutions and Islamic
Mutual Funds).

• IFSB-4: Disclosures to Promote Transparency and Market

Discipline for Institutions Ottering Islamic Financial Services
(excluding Islamic Insurance (Tukaftil) Institutions and Islamic
Mutual Funds).

• 1FSB-3: Guiding Principles on Corporate Governance for

Institutions Offering Only Islamic Financial Services (excluding
Islamic Insurance (Takaful) Institutions and Islamic Mutual
Funds).
 ORGANIZATIONS RELATED TO THE ISLAMIC BANKING SYSTEM 499

• IFSB-2: Capital Adequacy Standard for Institutions (other

than Insurance Institutions) Offering only Islamic Financial
Services.

• 1FSB-1: Guiding Principles of Risk Management for Institutions

(other than Insurance Institutions) Offering only Islamic
Financial Services.

The standards prepared follow a lengthy and stringent procedure

as outlined in the Guidelines and Procedures for the Preparation
of Standards/Guidelines established by IIFM. The preparation of
standards also calls for the issuance of exposure drafts for public
consultation which involves the organization of workshops and
public hearings when the occasion necessitate. In 2008, IFSB
published two industry guidelines which are:

• Guidance Note in Connection with the Capital Adequacy

Standard: Recognition of Ratings by External Assessment
Institutions on Syanah-compliant Financial Instruments.

• Technical Note on Issues in Strengthening Liquidity

Management of Institutions Offering Islamic Financial Sen ices:
The Development of Islamic Money Market.

In addition to these documents, the organization had issued

the Compilation Guide on Prudential and Structural Islamic
Finance Indicators in the previous year. With the issuance of the
Compilation Guide, a standard methodology for data compilation
and dissemination among institutions offering Islamic financial
services is now available to both market players and supervisory
authorities. In order to promote awareness on issues related to the
regulation and supervision of Islamic financial institutions as well as
create awareness of Islamic finance in non-Muslim countries, IFSB
has been actively involved in organizing international conferences,
seminars, workshops and dialogues around the world.
500 chapter9

ASSOCIATION OF ISLAMIC BANKING

INSTITUTIONS MALAYSIA

The Association of Islamic Banking Institutions Malaysia (AIBIM) is

an organization registered with the Malaysian Registrar of Societies.
The association was established on 12 July 1995 with the prime
objective of enhancing and promoting the establishment of sound
Islamic banking systems and practices in Malaysia. This endeavour
is accomplished in cooperation and consultation with Bank Negara
Malaysia and other regulatory bodies in Malaysia
AIBIM also functions as an organization that promotes and
represents the interests of members consistent with the laws of
Malaysia. The association also provides and promotes education and
training in order to upgrade Islamic banking expertise in Malaysia.
In pursuing the prescribed objectives, AIBIM establishes networks
with other similar associations, locally and abroad. In addition, the
association awards recognition to individuals and organizations
with outstanding contributions towards the development of Islamic
banking practices in Malaysia. The awards bestowed are the Islamic
Finance Figure and the Excellent Performance Award.
Membership of the association is of two categories, ordinary
membership and associate membership. Ordinary membership
is open to all Islamic banks, commercial banks, merchant banks,
financial companies and other financial institutions providing
Islamic banking services as approved by the Finance Minister of
Malaysia. Associate members comprise those considered qualified
and accepted by the AIBIM Council. These members, however,
are not eligible to represent the AIBIM Council and do not have
any voting rights at the general meetings. The management of
the association lies with II elected members and 3 co-opted
ordinary members. The elected members will appoint from among
themselves those who will hold management positions such as that
of president, vice president, honourable secretary and honourable
 ORGANIZATIONS RELATED TO THE ISLAMIC HANKING SYSTEM 501

treasurer. The daily management of the association is handled by

the executive secretary (www.aibim.com.my).

ISLAMIC BANKING AND FINANCE

INSTITUTE MALAYSIA

Tire BIMB Institute of Research and Training Sdn Bhd (BIRT), a

subsidiary of Bank Islam Malaysia Berhad. was the first institution
established with the main objective of promoting human capital
development in Islamic banking and providing understanding of
the Islamic banking system. This institute was incorporated under
the Companies Act 1965 on 13 April 1995, and began operations on
1 August 1995. Apart from organizing various seminars and short
training programmes, the institute also offers academic programmes
at the diploma level through an education institution known as the
Islamic Banking and Finance College. Among the diplomas offered
are Diploma in Accounting, Diploma in Islamic Banking, Diploma
in Marketing and Diploma in Takaful.
In line with the blueprint outlined in the Financial Sector
Master Plan launched in early 2001, the Malaysian government
proposed that an institution wholly owned by the Islamic finance
and banking industry be established (Bank Negara Malaysia, 2001).
Thus, BIRT was acquired by the industry and changed its name to
Islamic Banking and Finance Institute Malaysia Sdn Bhd (IBFIM).
The launching of this new institute was officiated by Tun Daim
Zainuddin, then the Malaysia's Finance Minister, on 19 February
2001. The shareholders of IBFIM comprise Bank Negara Malaysia
and 12 financial institutions that offer Islamic banking products.
IBFIM's vision is to become a leading international human
capita] and business developer in Islamic finance. In the area of
training and education. IBFIM provides two main programmes.
502 CHATTER 9

training programme and structured programme. Under its training

programmes, IBFIM is actively involved in organizing in-house
and public seminars, workshops and conferences in the area of
Islamic finance and management. The structured programmes
consist of certificate courses, skill-based courses in Islamic finance
and advanced programmes with international exposure. Currently,
IBFIM offers three types of certification programmes, namely
Islamic Certified Credit Professional, Islamic Financial Planner and
Shariah Scholars Induction Programme.
In the area of Syariah advisory and audit services, the activities
conducted include advisory services in the area of Islamic banking
and finance, takaful, unit trusts, mutual trusts, asset management,
sukuk, Islamic real estate investment trusts or REITs, leasing and
information technology. IBFIM also provides services such as
the screening of Sy<iri<i/i-compliant stocks and securities, the
development of Synrin/i-approved financial institutions as well as
Syariah audit services. The business advisory and development
area entails research related to the development and structuring
of Syariah-based products, models of Syariah-based operations,
Syariah accounting standards, risk management and Syariah asset
and liability management (www.ibfim.com.).

SUMMARY

Islamic financial institutions developed rapidly in the 1970s. As their

number increased substantially, it became apparent that a special
organization was needed to act as a liaison or arbitrator in resolving
issues of mutual interest to the Islamic financial services industry.
Die Jeddah-based Islamic Development Bank (IDB) is one of the
main catalysts in the establishment of Islamic banks worldwide.
This bank which was established in 1975, is the leading institution in
mobilizing wealth of Muslim countries through cooperation among
 ORGANIZATIONS RELATED TO THE ISLAMIC BANKING SISI I M 503

them as well as in raising the economic level of least developed

Muslim countries. Projects implemented by IDB are intended to not
only benefit its member countries but also Muslim communities
in both Muslim and non-Muslim countries. The bank runs four
categories of programmes, namely project financing, technical
assistance and witqf fund operations, trade finance operations and
activities of specialized funds and its affiliated institutions.
Apart from IDB, several organizations whose members are
Islamic financial institutions have also been set up with the objective
of protecting the interest of its members and implementing
activities of mutual benefits. The first organization of this kind to
be established was the International Association of Islamic Banks.
This organization was unfortunately dissolved in 1997 after 30 years
in operation. In its place, the General Council for Islamic Banks
and Financial Institutions was launched in Bahrain. However,
the council has yet to make its presence felt in the industry as its
activities are limited to organizing seminars and conferences. At
the national level, associations such as the Association of Islamic
Banking Institutions Malaysia was established to protect the mutual
interest of its members that are local Islamic financial institutions.
The association is also committed to promoting and enhancing the
development of Islamic banking.
In order to complement these organizations, institutions whose
membership comprise the central banks and monetary authorities
were established. For instance, the Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI), which is
based in Bahrain, was established specifically for handling matters
related to accounting and auditing standards of Islamic financial
institutions. Islamic Financial Services Board (IFSB) centred in
Kuala Lumpur was established to ensure the soundness and
stability of Islamic finance through regulating and supervising the
industry. The International Islamic Financial Market (IIFM), based
in Bahrain, is responsible for the promotion and development of
Islamic financial instruments in the secondary market.
504 CHAPTER 9

With respect to education and training, a number of

organizations at both the national and international levels such
as the Islamic Banking and Finance Institute Malaysia and the
Jeddah-based Islamic Research and Training Institute, have been
established for the purpose of creating human capital in Islamic
banking.

REFERENCES AND FURTHER READING

Bank Negara Malaysia. Financial Sector Master Plan. Kuala Lumpur,

2001.

Islamic Development Bank. Annual Report (various years). Jeddah

(Saudi Arabia).

Musa Kamal, Rahayu. "Standardization: The Password to Progress."

Islamic Finance News, August/September 2008: 28-30.

www.aibim.com.my

www.banking-business-review.com

www.ibfim.com

www.ifsb.org

www.iifm.net

www.isdb.org

www.islamicfinanceonline.com/gcibfi

www.Lariba.com

www.mcca.com au
 GLOSSARY

A'mil .4/isa« al-hadith

Plural for mil (work) necessary The best spoken words.
in a partnership, or terms stated
at tile time of establishment of Ajal

the partnership. Period of time; period in which

delivery is deferred.
■Abd

Worker; 'abd ma'dhun is a Akhlaq

worker who has been the Behaviour, actions and work

authority to perform a task on ethics.
behalf of his employer.
Al-adillat-al-iilihadiyyah

Ahad Views or opinions acquired

The term used for a hadith through thorough thinking
narrated by only one narrator and perseverance in resolving
or coming from only one problems at hand. In Syariah, it
source. refers to ijma and qiyas,

Ahkam al-muamalal al-lslamiah Al-adillat-al-qatiyyali

Islamic muamalah rules. Views or opinions which are

absolute, whose truth cannot be
Ahkam disputed. In Syariah, this refers
Regulations or instructions, to the Quran and hadilh.
rules. Singular hukm
Al-amin

Ahliyah Reliable, honest, trustworthy.

Legislative capacity.
Al-arabun

Ahliyat al-ada' See urbun.

Legislative capacity to perform

a certain responsibility-

505
506 GLOSSARY

Al-bai bithaman ajil Al-Hakim

See bai bithaman ajil, That which/who judges or

executes rules.
Al-Bayan

Explanation. Al-ijarah

See ijara.
AI-Burhan

View. Al-ijarah thumma al-bai

Rent or lease which provides

Al-Dikra and option to purchase by the
Provider of reminders, or tenant or lessee. It is one of
source of nobilit}'. the Syariah principles used by
the Islamic Banking System in
Al-Furqan Malaysia.
That which discerns between
the truth and faslehood Al-kafalah

or between authentic and Guarantee. It is a guarantee

corrupted. made by a person to the
owner of an item who places
Al-Haqq the item with a third party.
The truth. In the event that the owner
submits any claims on the item,
Al-hawala
the guarantor is required to
Transference of debt from one fulfil it. It is one of the Syariah
person to another. Also termed principles used by the Islamic
al-hiwalall. One of the Syariah Banking System in Malaysia
principles in Islamic Banking (commonly called kafala).
System (normally termed
liiwalah), Al-khair

Good deeds; good.

Al-Hikmah

Wisdom. Al-Mau'izah

Advisor or criticizer.
Ai-hiwalah

See Al-hawala.
 GLOSSARY 507

Al-Mofaviza Al-Tadhkirah

General partnership (it is Remembrance or mindful of

a form of partnership in Allah.
musyarakah).

Al-Tanzil
Al-mudharabah
A form of guidance that
See mudharabah.
descend from elevated sources
Al-muhaimin such as revelation (wahyu) from

Guardian; protector. Allah the Most High.

Al-murabahali Al-ujr
See murabahah. A commission or fee charged
on a service provided. It is one
Al-musyarakah
of the Syariah principles used
See musyarakah.
by the Islamic Banking System
Al-Naimah in Malaysia.
Blessing.
Al-urbun
Al-Nur See urban.
Light.
Al-wadiah yad dliamanah
Al-qardhul hasan
Deposit on Trust with security
See yard hasan.
or guarantee, where the trustee
Al-Qayyim guarantees to return the items
Guardian; protector. involved on demand. It is one
of the Syariah principles used
z\l-Rahmah
by the Islamic Banking System
Forgiveness.
in Malaysia.

Al-rahn
Al-wakalah mat
See rahn.
An agency contract between
Al-Ruh two parties where one party
The life of life. act on behalf of the other a
specified in the contract.
Al-Shifa

Healer. Al-wakala al mutlaija

Absolute Agency.
508 GLOSSARY

Anial Arboon

Work or action. See arbun,

Amil Ardh

See mudarib; also termed amel. Land. The majority of jurists

have the opinion that land
Amwal owner does not qualify
Plural for nial (wealth). to receive rights to profit
Wealth released as capital in a compared toother factors
partnership. like wealth, labour and credit
capability.
Ansar

Muslims in Madinah that Arkan

provides assistance to those Elements or qualities of an

who flee from persecution action, the absence of which
in Mecca during the Meccan results in the action being
period. invalid.

Aqa'id Arsh
See aqidah. Compensation due to inflicting
injury.
'Aqd

Agreement or contract. As-salam

Sales and purchase concept

Aqidah where the price is paid in
The form of faith and belief of advance for an item which will
Muslims in Allah s.w.t. Also be delivered later.
termed aqa'id.
AsMi al-mizul
Aqilah
Tile reason for the sending
Persons having family ties down (of a Quranic verse).
or cooperative connections
and who assist in unintended Albanian mutlaqah
killings. They are, together with Absolute currency. It refers to
the killers, held responsible the use of dinar and dirham.
by law to indemnify "blood
money".
 GLOSSARY 509

Awqqf Bai'al-lnah

Property transferred A sales contract which

voluntarily for trust keeping, involves the processes of
to be utilized for the welfare of - sale and repurchase between
the public. two contracting parties. For
example a seller will sell
Ayah
an item by credit and then
Guidance signs or a repurchase it by cash at a lower
communication from Allah price compared to the original
s.w.t. Singular form: ayat. selling price. This system is
It refers to the verses of the adopted by the Islamic banking
Quran. system in Malaysia.

Ayn Bai' al-istijrar

Tangible goods or property A sales contract which involves

with physical form. repeated deliver)' of goods at a
pre-agreed price and payment
Aziz mode. It is also commonly
The term used for a hadith with known as istijrar.
only one narrator, where the
individual is highly reliable Bai’ al-istisna

and is accepted as a narrator of Order sales (see istisna).

hadith.
Bai' almuzayadah
Bai' Sales undertaken by a certain
A general term which is used to party in the open market by
mean sale and other exchange tender, where the sale will be
transactions or contracts. executed to the party offering
the higher price.
Bai al-dayn

Sale of Debt. It is applied Bai al-urbun

to debt financing where its Sale with advanced payment or

existence is based on trade down payment.
documents. It is one of the
Syariah principles used by the Bai' al-wafa'

Islamic Banking System in A sales conditional contract,

Malaysia. where the seller pays back
510 GLOSSARY

the selling price to the buyer Da'if

and the buyer returns the Weak. It is a term used for a

purchased goods. hadith which is not strong and

which will be rejected if it is

Bai' bithaman ajil one that touches on religious
Increment on the cost with command or prohibition. It
deferred payment, or deferred may be taken as a guide if it is
payment sale, also referred to in the form of advice, fable or
as bay' mujjal or bai muazzal. good behaviour. See sakim.

Bai' muazzal Dar al-harb

See bai' bithaman aji. This Country or region that has
method is used by Islamic the potential to be at war with
banks in Bangladesh in their Islam.
real estate financing.
Dar al-lslam
Bai'-salam
Country or region under
Salam sale where the buyer
Islamic rule and applying
makes an immediate payment
Islamic law.
and the seller defers the
delivery of the goods to a
Daral-sulh
certain period in the future.
Country or region that has an
Also termed baiul-salam.
agreement with Muslims.

Bay' bi'l-nasiah
Darb
Sale by credit.
Efforts put in on the face of the
earth.
Bay' niuijal

See bai bithaman ajil.

Dayn/dain

Loan, debt, or receivables.

Buda'ah

The item submitted to another

Dayn mu'ajjal
party to be traded without
Debt increment due to
involving any reward or profit
extension of loan period.
sharing.
 GLOSSARY 511

Dhaman Fasidun

Compensation or obligation. People who cause destruction

or woe.
Dhaman al-'amal

Responsibility that exists in a Fasiqiin

partnership based on expertise, Those who rebel.

where one of the partners is
responsible in implementing Faskh

a contract or in completing a Cancellation or dissolution.

task agreed upon by the other
partner. Fatwa

A ruling issued by authorities

Dhaman al-thaman in Islam.
Responsibility that exists in a
partnership based on credit Furu

strength, where every partner Branch. Singular: far,

is jointly or individually
Ghaib
responsible in paying the price
of the goods bought by credit. A term for hadith which comes
from only one source, that is,
Din whether from the Companions

Obedience, compliance; or those who lived after them.

practice; conform.
Gharim

F'tf The debtor who fails to pay

Action or doing. debts from outstanding

obligations.
Far

Seefuru. Hadith/hadis

Information, narration, story,

Fard reports or records of the sunnah
A term for hadith which is of the Prophet Muhammad
narrated by one narrator at p.b.u.h.
each level, or which is narrated
by narrators in the same district
only.
512 GLOSSARY

Hamish jiddiyyah Hiyal

Initial payment or deposit paid See hila. It is a concept amongst

by a buyer who intends to buy those in the Hanafi mazhab,
a certain item. whereby an established
partnership is not limited
Haram and possesses rights or
Shariah ruling that prohibits or contributions that are equal and
consider something forbidden. balanced amongst partners.
One of the ahkam in Islam.
I'klikadat
Hasan Rule, stipulation.
Good, reasonable or
appropriate. A term used for Ibadah

hadith which can be adopted Action with respect to

worshipping Allah.
Hizim

Binding; a contract which is Ibahah

binding. Truth.

Hibah Ibra'

Gift. The process of cancelling one's

own rights. For example, a
Hila person has the right to claim
Plural form: hiyal. It is a type payment of debts owed to him
of juristic instrument which by a debtor, but he cancels that
is created to accomplish right by cancelling the debt
something which is in principle concerned.
conflicting with Syariah. This
application is only found in Ijara

the 1 lanafi and Shafii mazhab. Rent or lease. Also called

Hanbali and Maliki mazhab do al-ijarah. It is an agreement
not object to its use. where a property owner will
rent or lease out the property
Hiuvlah to a tenant or lessee for a
See al-hiwalah. stipulated period. In return, the
tenant or lessee will provide
 GLOSSARY 513

rental or lease payment Haiti

according to the predetermined See kudsi.

amount and time. It is one of

the Syariah principles in the Illa

Islamic banking system. Reasoning created through the

same process. Plural: Hal.
l/ara wa-iqtina

Hire purchase contract or lease Ilin al-ma'ani

purchase contract, whereby at Knowledge of rhetoric or the

the end of the lease period the art of effective usage of words
ownership right of the lease or flowery language.
asset will be transferred to the
tenant. Ilm al-tajwid

Knowledge of Quran recital.

Ijma

Mutual agreement, opinion or /non

collaborative stand. It is one of Limited investment partnership.
the sources of Syariah.
hum syarikat mal

Ijtihad Limited financial partnership,

The practice or method of financial participation.

problem solving, or the
Intiha'
process of mental perseverance
undertaken with full Termination, end, dissolution

concentration and commitment or cancellation of a partnership.

to solve a particular issue,

Iqala
especially that related to
See ikala.
religion.

Isnad
Ikala
Links of a hadith.
Reciprocation or replacement.
Also termed as iqala, i.e.
Isqat
cancellation of contract on
Elimination or cancellation of
mutual agreement.
rights.
514 GLOSSARY

Istikhraj tins

Conclusion drawn by method From the same type, genus or

of analogy. See istinbat. group.

lo’alah
Istinbat

To search and draw on a Service charge, i.e. a guarantee

hidden meaning bv the process where the party requiring

of ijtihad. Also termed as a sendee will pay a certain

istikhraj. amount of charges to the party

providing the service. This is
Istisna one of the Syariah principles

Contract for the manufacture or used in the Islamic banking

production of particular goods. system in Iran.

Kafil
Istijrar
See bai al-istijrar.
Person who guarantees.

Kafirun
'luvidh
Person whose faith is not
Compensation, replacement
within Islam.
value.
Kalam-Allah
/a'iz
Words of Allah S.W.T.
An action whether executed or
disregarded, results in neither Khiyar

reward nor sin. Also termed as Option or right Plural: khn/arat.

iniibab.
Khiyar al-ayb

/ami Option or right given to the

Something gathered or buyer or tenant to revoke

accumulated together. Also on discovering defects on

termed as innsannaf. the goods intended to be
purchased or rented.
lihalali
Khiyar al-ru’ya
Unknown or uncertainties in
Option or right given to the
a contract which may cause
buyer or tenant to revoke after
disputes in the future.
inspecting the goods intended
to be purchased or rented.
 CLOSSARt 515

Khiyar al-shart Majmul

Option or right given to the Brief.

buyer or tenant subject to
specific conditions. Makbul

Accepted. The term for

Khiyar al-wasf the hadith which fulfils all
Option or right given to the conditions for it to be adopted.
buyer or tenant based on the Hadith of this category are also
quality of the goods involved. normally grouped as sahih or
hasan hadith.
Kudsi

The term used for the hadith Makrult

which contains Allah’s Action which is not encouraged

revelation. This type of hadith is but neither is it forbidden, and
taken from Allah's Messenger’s doing it will not result in sin or
sunnah and is termed nabau’i abhorrence. One of the ahkam in
hadith. Other terms used are Islam.
ilahi or rabbani hadith.
Maktu

Lazim The term for the hadith whose

Ties, bond. origin of isnad is linked
directly to the people after the
Ma'lul Companions.
See mu'allal.
Mandub
Mahfuz See sunna.

Stuck in the mind. The term

used for hadith in the category Manilla

of hadith which can be adopted. To accord the right to utilize an

Its status is higher than that of asset for a certain period to a
hadith of the shadhdh category. person who is in need of it.

Mahjoor Mansukh

Person prohibited by law See nasikh.

to undertake contracts or
businesses.
516 CLOSSARS

Mardud Masnun

Rejected. The term used for See surma.

hadith which is classified as

not adoptable. This hadith Main

comes from weak or unknown Content of hadith.

narrators, and what is narrated
differs from the narration of Matruh

others who are reliable, See Disposed of. The term for hadith
munkar, matruk, matruh, and which cannot be adopted. The
mawdu. hadith come from narrators

known to be untruthful or
Marfu who openly misbehaved and
The term for hadith whose told lies. See mardud. munkar,
origin of isnad is linked directly matruh, and mawdu.

to Allah's Messenger p.b.u.h.

Mawdu

Maruf Imaginary, made up. The

Acceptable. The term for term for hadith which cannot
hadith classified as that which be adopted. The hadith are
can be adopted. It is however made up on purpose and are
considered weak and is verified regarded the most dangerous
by other hadith of the same and of lowest status. See
standing with it. mardud, munkar, matruk, and
matruh.
Marufat

Good. Mawkuf

The term for hadith whose

Masaqal origin of isnad is linked directly
A contract whereby the owner to the Companions of Allah’s
of trees would hand over Messenger p.b.u.h.
his trees to another party to
manage it. and the profit would Milk mushtarak

be distributed according to an Joint ownership.

agreed upon ratio. Also termed
as mosayat. It is one of the Modaraba

Syariah principles used by the See mudarabah.

Islamic Banking System of Iran.

 GLOSSARY 517

Modarabah Muamalat
See mudarabah. Business or commercial
transactions or activities
Mosaqat ' involving contracting parties.
See masaqat.

Mu'ayyan
Mozara'ah Specification of goods through
A contract where a landowner weights and measures for the
assigns his land to be worked purpose of transaction or sale.
on by another party for a
certain period, and the profit Mubham

will be divided according to a Vague or unclear.

mutually agreed upon ratio. It
is one of the Syariah principles Mudarabah

used by the Islamic Banking Partnership. Also termed as

System of Iran. modarabah, al-mudharabah,

and modaraba. Also known

Mozare as qirad and muqaradah. The
The landowner in the mozara'ah concept is applied where the
contract. investor who allocates capital
to entrepreneur to undertake
Mozarebeh a business will not interfere
See mudarabah. in the business or enterprise.
Profit is shared according to a
Mu'allah pre-agreed upon ratio whilst
Suspended, hanging. The term loss is borne by the investor.
used for the hadith where one One of the Syariah principles in
or two or all the names of the Islamic Banking System.
narrators are not mentioned in
the isnad. Mudarib

Entrepreneur who undertakes

Mu'allal business on someone else's
The term used for hadith which capital. Also called amil and
has weaknesses or defects in its rabb al-mal.

isnad or matn. Also termed as

ma'lul.
518 GLOSSARY

Mufawada Munafa'a

The concept used by the Manati Usufruct or utility.

mazhab for equal partnership in

terms of capital issued between Munfasil

the partners and in other The term for hadith with broken
matters, links in the isnad. See inunkati.

Muhajirun Munkar

Tlte people of Makkah who Disregarded. The term for

perform the hijrah to Medina hadith which cannot be

with Prophet Muhammed adopted. Narrated by only

p.b.u.h. one narrator and differs from
the narration of others with
Muhaqalah credibility. See mardud, ntalruk,
The sale of food product which matruh. and rnawdu.

is not yet harvested. (This type

of sale is not allowed in Islam.) Munkarat

Vice or evil doings.

Muhkamaat

Clear and concise in meaning. Munkati

The term used by Imam Shafii

Mujtahid and al-Tabrani for hadith with
Persons with expertise in broken isnad.
Islamic law and other branches
of the religion. Muqaradah

See mudarabah and qirad.

Mukhabaralt

Contract regarding sharing of Muqasah

agriculture produce, where Amortization of debt through

the landowner places an order contra transactions.
for the produce at a selected
area. (This kind of contract Murabahah

is forbidden.) Also termed Increment over cost or cost

as musaqah, which refers plus mark up. also termed as
to transactions with Jews at al-inurabahah. It is one of the
Khaibar. Syariah principles used by the
Islamic Banking System.
 GLOSSAB1 519

Mursal be shared according to capital

The term used for the hadith contribution ratio. It is one of
where the narrators after the the Syariah principles used in
time of the Companions quoted • the Islamic Banking System.
tile words of the Prophet
directly, without mentioning Mutasyaabihaat

the names of the Companions. Vague, and the actual meaning

cannot be determined.
Musannaf
See jami. Mutawatir

The term for hadith narrated by

Mushrika many narrators with no dispute
See nnisyarakah amongst them.

Mushrikotm Muttasil inarfu

Opposers of Islam during the The term for the hadith where
time of Allah's Messenger the isnad is not broken and
p.b.uJi. is linked directly to Allah’s
Messenger P.B.U.H.
Musnad

Authority. Also termed as Muttasil mawkuf

sanad. The term for the hadith

where the isnad is not broken
Mustahabb and linked directly to the
See surma. Companions.

Musyarakah Muzayadah

Joint venture. Also termed as See bai al-muzayadah.

al-musyarakah, and mushrika. A

concept where several investors Nabal al-bi'ra

cum entrepreneurs provide To dig a well that releases

capital for a business venture. water.
Tile investors participate in
the management. Profit is to Nabawi

be shared according to a pre­ lhe term for hadilh taken from

agreed upon ratio and loss is to the sunnah of Allah's Messenger

520 GIOSSAJll

p.b.u.h. It contains Allah's Qiyas

revelation. Also termed hadith Juristic instrument in the form

kudsi. of comparison by analogy. It is
one of the sources of Syariah.
Nasa'a
See nasiah. Qal

Speech.
blasiah

Delay, deter or wait. Taken Rabb al-mal

from the word nasa’a. See mudarib.

Nasikh Rabbani

Cancellation. Also termed as See kudsi.

niansukh.
Rabia

Qard Hill or high land.

Loan,
Rahn

Qard al-hasanah Pawn or security. Also termed

See qard hasan. as ar-rahn. It is one of the
Syariah principles in the Islamic
Qard hasan Banking System in Malaysia.
Loan for welfare or goodwill.
Also termed as qard al-hasanah, Riba

al-qardhul hasan and Interest or interest rate.

qan-e-hasna. Il is one of the
Syariah principles in the Islamic Riba al-buyu

Banking System. See riba al-fadl.

Qard-e-hasna Riba al-duyun

See qard hasan, See riba al lahiliyya.

Qirad Riba al-fadl

Trust financing, profit sharing Riba that emerges from trade

of trustees;, and equity sharing. and sale transactions involving
Also termed as mudarabah or ribawi commodities. Also
nuiqaradah. known as sales riba. Also
 GLOSSARY 521

termed as riba al-hadith. riba Riba Al-Quran

al-sunnah, riba al-buyu, riba ghyr See riba al-jahiliyya.

al-mubashir and riba al-khafi.

Riba al-sunnah
Riba al-hadith Sec riba al-fadl.
See riba al-fadl

Riba ghyr al-mubashir

Riba al-jahiliyya See riba al-fadl.

Riba which existed before Islam

became established. It emerged Ruhul-kudus

as a result of extension of debt Holy spirit.

period and is commonly called
debt riba. Also termed as riba Saddadah-dhara'i

Ai-Quran, riba al-nasiah. riba Barrier to the use of a certain

al-duyun, riba al-mubashir and method. It is a principle formed

riba al-jali. by the Maliki mazhab to bar
the use of methods allowed
Riba alfiali by Syariah to attain objectives
See riba al-jahiliyya. which are by origin haram.

Riba al-khafi Sahib al-mal

See riba al-fadl. Fund owner of investor.

Riba al-mubashir Sahih

See riba al-jahiliyya. The term for hadith which can

be adopted.
Rtba al-nasiah

See riba al-)ahdiyya. Sakim

Not significant. The term for

Riba al-yaradali hadith which is not strong and
Riba which emerges due to the which will be rejected if it is
creditor asking for additional one that touches on religious
payment because of the commands and prohibitions.
lengthening of the normal debt It may however be used as
a guide if it is in the form of
advice or narration of good
behaviour.
522 ctossAiu

Salam ahkam in Islam. Also termed as

See bai’ salam. masnun, mandub or mustahabb.

Samsarah Sunnah

Broker, agent or business that Ways, rules or behaviour in life.

attains commission. In the context of Syariah, it
refers to behaviour, action.
Sanad reaction, tacit approval and
See musiuid. utterances of Allah's Messenger
p.b.u.h. in various situations in
Sandauq al-zakat life. Plural: sunan.
Zakat funds.
Sunnat al-aunvalin
Shadhdli The ways or examples of
The term for hadith that people in the past.
comes from only one reliable
source, and the contents Sura
differ somewhat from what is Noble or pure. Singular, surat.
narrated by other narrators. It refers to the verses of the
Quran.
Shirkatul meellt

See syarikat mulk. Surat

See sura.
Shurut

Conditions or terms. Syahadah ad-dayn

Debt certificate
Sukuk

Certificate of proof of debt or Syar

proof of investment. Path or way leading to water.
See syariah and syara'a.
Sunan

See sunnah. Syariah

Path or way. Also termed as

Sunna
syar. Commonly known as
Action which is promoted Islamic law.
but not obligated. One of the
 GLOSSARY 523

U/r
Partnership. See musyarakah. See al-ujr.

Syarikat ‘aqd Ummat Al Islam

Joint partnership. It involves The Islamic community as a

joint partnership in capital whole or the Muslim ummah.
issuance as well as in the
management of the venture Uqud

concerned. Akad, promise, pledge or

responsibility.
Syarikat a'mat

Workforce or manpower Urban

partnership. In this case, Also termed arbrnm. It is a ty'pe

experience and expertise of of deposit or initial payment
partners are important criteria as part payment of goods
in establishing the partnership. or services intended to be
purchased and which will not
Syarikat mal be void if the transaction is
Financial partnership. In this discontinued. (According to the
case, cash is an important Hanbali mazhab it will be void.)
criteria in establishing the
partnership. Usui

Roots or origin or primary

Syarikat mulk source.
Asset partnership. Also
termed as sliirkatul meelk. It Usui al-fiqh

only involves partnership in Knowledge of the origins

ownership on an asset and does of Islamic law or Islamic
not involve any joint enterprise Jurisprudence.
in the development of the asset.
Wadialt

Syarikat wujuh Trust. Also termed al-wadiah.

Credit partnership In this case, It is trust that is entrusted
partnership is based on credit. by a property owner to
another party who will keep
Tayrir the property and returns it
Implicit truth.
524 GLOSSARY

on demand. It is one of the Warik

Syariah principles in the Islamic A type of currency in the

Banking System. beginning era of Islam. It
originated from silver which
Wahy matluww was molten down to form
Revelation that is read. dirham.

Wa/ib Yastinbitun
Seefard. See isttnbat.

Wakalah Zdlimun
See al-wakalah. Persons who commit injustice,
vice or wrongdoings.
 INDEX

A Al-Rajhi Company 56
Al-Shatibi 28
AAOIFI See Accounting and
Al-wadiah yad dhamanah 130,
Auditing Organization for
140, 299
Islamic Financial Institutions
Albaraka Bank 69,271,488
ABC Islamic Bank 406
Albaraka Investment and
Abraham 15
Development Company 55, 72
Abu Dhabi Islamic Bank 270,406
Albaraka Islamic Bank 270, 299,
Abu Yusuf 17
331,334, 351
Accounting and Auditing
Albaraka Kazakhstan Bank 46
Organization for Islamic
Albaraka Turk 304-305,307,315,
Financial Institutions 58-59, 62,
317,320, 322-323,343,345-346,
269.271,275-276, 279. 285, 296,
351
323-324.329.331.340. 342,344,
Albaraka Turkish Fin. House 56,
347-349,354, 437-491, 495,503
72
Accounting and Auditing
American Finance House 46
Standards Board 489-490
Amlslamic Bank 393
Agricultural 137,188,307
Aqidah 224-226
Akhlaq 224-225
Aquinas, Thomas 10
Al-Amanah Islamic Investment.
Arabic Insurance Company 432
Philippines 105
Aristotle 176,184
Al-Ameen Islamic & Financial Inv.
ASEAN Retakaful International
Corp. 56
Ltd 434-435
Al-Farabi 17
Asian Finance Bank 78
Al-Ghazali 17,28
Assets 85,302,318-322. 329,
Al-ijarah al-muntahiah
332-333. 344-346, 368-370,373,
bit-tamlik 138
384-385, 389,398-399, 403-404,
Al-ijarah thumma al-bai 130, 138
407
Al-Izz bin Abdus Salam 17
Association of Islamic Banking
Al Rajhi Banking & Investment
Institution Malaysia 463,500,
Corporation 78, 488
503

525
526 INDEX

Association of Islamic Banks 461 Bank Muamalat Indonesia 103,

Az-Zubair 48-50 104-105,113. 252,257, 270, 291,
293,301,304-305, 307,315-316,
B 318, 320-321.323, 326,332.340,

344. 351
BADR Bank 46
Bank Muamalat Malaysia Berhad
Bahrain International Sukuk 495
76-77, 99. 110, 286,343
Bahrain Islamic Bank 55,270
Bank Negara Malaysia 57, 73-80,
Bahrain Islamic Inv. Company
138. 259-264,271,315,332,
55
352.368,377,384,386,388-390,
Bahrain Islamic Takaful Company
392-393,401, 411-412, 420,
433
429-431,434-436,457.493,
Bai al-dayn 130, 141, 291,375, 379,
500-501
388-391, 397, 404
Negotiable Note 389-390,401
Bai-al-inah 142,290. 293, 388-389,
Bank of England 44
392,397,399-401
Bank Perkreditan Rakyat 105
Bai bithaman ajil 141, 158, 290,
Bank Syariah Mandiri 293
294.304- 306,375,387,392,
Basel
394-396, 419
I 350
Bai istijar 142, 290, 293,378
II 316,350,355
Bai muajja) 158
Basel Committee on Banking
Bai muazzal 129, 303, 319
Supervision 497
Bai murabahah 158
Bills 47, 265,319,375,380,387,
Bai muzavadah 366,397,399
391-392
Bai salam 133, 142,158,290,378
BIMB Institute of Research and
Bait Ettamouil Saudi Tounsi 56
Training 501
Baitulmaal Muamalat 326
Board Risk Committee 352
Banco Della Pizza 4-1
Bolshevick Revolution 13
Bank Asya 295
Bonds 112.213,321-322,362,
Bank for International Settlements
367-375,379,381-384, 394-397,
350
399-109, 414,418
Bank Islam Malaysia 55, 75, 98-99,
Khazanah 397-398
145, 253, 259-260,270, 276,
Brezhnev, Leonid 13
286.301.304- 307,310, 314-318,
Buddhist 17
320-322,331-332,34(1,344-345,
Bukhari Capital 488
348-350, 366, 388, 40b, 456, 501
Bursa Malaysia 79,413
Bank Meili Iran 301
 INDEX 527

c Dubai Islamic Bank 54-55,60, 99,

101, 145, 270, 291,301, 304-307,
Cagamas 382-383,409-410,420
320,323,326-327,331,334,341,
Caliph ar-Rashidin 47
' 343,345-349,351, 406
Caliph Omar al-Khattab 2
Capital Market Master Plan
E
415-416, 420
Central Bank of Malaysia See Economic system 6-9, 18-19,35,
Bank Negara Malaysia 93,211,287

Christian 164, 166-168,170-172, capitalism 9,12

178-179, 181-182,203-204,215 capitalist 11,38,94
C1BAFI See General Council of communist 12-13
Islamic Banks and Financial individual capitalism 10
Institutions Islamic 1-2,18-19,35,
Code of Hammurabi 164, 427, 38-39
456 open 10
Communism 10,12-13 social capitalism 10
Companies Commission of socio-capitalist 94
Malaysia 362 socialism 9-12
Conventional banks 44-45,58, socialist 10-12,38, 94
68, 70-71, 75, 85-87,94-97, 113, West 2
118-119, 147,149-152,155, Economic theories 28, 95
157-158,216,261-262,264-265, Economics
271, 285-286,308,327,329,347, capitalist 2
354-355, 360, 390.424 definition 2-5,14
Currency 300,411-412 Islamic 16-18, 23-24,
33-34
D Marxist 2
methodology 18-19,23
Dallah Albaraka 108-109
socialist 2
Daral-Mal al-Islami 45,55,
Western 31
106-107, 432
Educational institutions 46.
Depositors 52,118,140,147-148,
113
151-152,158, 267
Egyptian Saudi Finance Bank
Depreciation 344-346
67-68
Doubtful debts 342-343
El Gharb Islamic Bank of Sudan
Dow Jones Islamic Index 59,62
329
528 iNnex

Entrepreneurs 63, 156-157, 159, Financial markets 359-361, 383,

466 386,410-411, 418-420, 493-494
Etiqa Takaful 436,448-450,453, capital market 361-362,367,
454 379, 412-413, 415-420,493
forward markets 378-379, 419
F futures market 361,378-379
money market 361,375-377,
Facilities 94,139,147, 155,
379,384,390, 393,412,
263-264, 295, 297-302,308,
419-420,499
311-315,317-318.347, 354,359,
mortgage market 361,380,
376,392
382-383,419-420
Faisal Finance Institution Inc. 56,
unit trust market 383
73
Financial Reporting Standard 346
Faisal Islamic Bank of Egypt 55,
Financial Sector Master Plan 57,
63,65,66, 68, 74,254,270,274
77-78,501
Faisal Islamic Bank of Sudan
Financial statement 323, 329-331,
54-55, 69, 74
349,355,488-489,491
Fasakh 136
Ford Foundation 64
Fatwa 51, 210,213,252,269, 271,
276,366,370,463,490,492
G
Faysal Islamic Bank of Bahrain
270 General Council of Islamic Banks
Financial Accounting Standards and Financial Institutions 463,
Board for Islamic Banks and 491-492, 503

Financial Institutions 491 Gharar 424, 456

Financial institutions 45-46,52, Global Master Repurchase
57,60,62, 76,95,107,112, 116, Agreement 497
118-119, 269, 277,349,371,376, Gorbachev, Mikhail 13
381-383, 388-390, 393, 411, 462, Government Investment Issue
470,478, 484, 487-491,494, 496, 387-389,393
498. 501-503 Greeks 174- 177
Financial instruments 76, 149,
261, 359-362,368, 370-371, 375, H
377,379,386-390,392-393,397,
Hadith 15,22-24,31-33,36-38,
418-420, 466,493-494, 496,499,
44.49,117, 121-122, 125-126,
.503
128-129,149, 153-154, 158,
 iNDrx 529

187-188. 192-193,197,201-203, Insurance 423-434, 437, 440, 444,

205, 214-215,222,227-228, 455-456, 498-199
231-236, 240-241, 243-245, Insurance Islam TAIB Sdn Bhd
248-249, 251,278,354,379. 433
438-440 Interest 94,164-165,167-168,
classification 236-239 170-187, 213-215.255,265,
Halal 107,213-214,216 337-338,359,362,367-368,376,
Hanafi 130, 133,136, 203-205, 381
210 acceptance 164
Hanbali 130.133,135, 204, 207 concept 170-186
Haram 186, 212-214, 216, 278 definition 165-168
Hibah 140.250, 291,317,368,388 Interest-free Banking Scheme
Hierarchy of Needs 28 57
Hinduism 171 International Accounting
Hiwalah 142, 150,159,246. 250, Standards Board 33!
291, 294 International Association of
Hival 130 Islamic Banks 87,296, 459,461,
Hongkong Shanghai Banking 462-463,503
Corporation 406 International Bank for Investment
and Development 63,66
I International Capital Market
Association 497
Ibadat 225. 248
International Centre for Biosaline
Ibn Khaldun 17
Agriculture 482,486
Ibn Rushad 17
International Currency Business
IFSB See Islamic Financial Services
Units 79
Board
International Islamic Banks 55,
Ijarah 129, 136-137, 145, 149,159.
79
250,289,291, 294.303,305,319,
International Islamic Financial
334,374-375,380,387, 401-403,
Market 57,463, 493-497,503
405,407. 419, 495-496
International Islamic Rating Body
Ijarah wa-iqtina 129,137,291, 404
62
Ijma 36-38,121,222,227-228,
International Islamic Trade
239-240,246,248,251, 278
Finance Corporation 480-481
Ikala 136
International Monetary Fund 59,
Indian 171-172
61,287
Industrial revolution 11
530 iNorx

Investment 38, 63,67-68, 76, 96, Islamic Development Bank 54-55,

102,113,174, 266,285, 298,302, 58-59,71,87, 113,328-329,
319-323.333,335-342. 347,351, 373,406.459,461,463-476,

359, 361,363,366,369,373, 478-480-483,485,488, 492-493,

377-378383, 385,387-388,393. 495,502-503

415-417, 441.418, 444. 449-451, Islamic Economic Research Centre

454-455, 461, 464, 467, 478, 60
481-482, 490-491, 498 Islamic Financial Services Board
Investment and Development 58,62,331, 463,492,497-499,
Body of Islamic Countries 503
460 Islamic International Arab Bank
Islami Bank Bangladesh 103, 305-307,315,317-318,320,
110-111, 270,291,301,305,307. 322-323,331.343.345,347-348.
313,315-316,318,320-323, 325, 351

343-344, 347 Islamic International Bank tor

Islamic Bank for Western Sudan Investment & Development
69 55, 65,67,254-255
Islami Bank Foundation 325 Islamic International Finance
Islamic Market 374
banking system 57,59.68, 75, Islamic Investment House 55
80-84, 86, 105,140-141,144. Islamic Research and Training
146, 245, 259, 268-269, 360, Institute 482, 485,504
393,419,457, 459,463 Istisna 129,133,142-143, 158, 290,
economics 16-17,19,24-26, 293,305,333-334,375,378, 468,
29-31,34, 465 470,473,483-484,496
thinkers 16-17,24
Islamic Bank International 55 J
Islamic Bank of Britain 46
lews 170-174, 180,188-189,215
Islamic Bank of Thailand 106
prophets 170
Islamic Banking and Finance
Joalah 130, 143, 159, 294-295,302,
Institute Malaysia 501-502.
337
504
Jordan Islamic Bank 55, 110,270,
Islamic Banking System
272, 291,324,338,349,351,
International Holdings 45,55
370-371
Islamic Cooperative Development
Judaism 164
Bank 69
 INDEX 531

K Finance Companies Act 1969

263
Kafalah 143,15(1, 159, 250, 291,
294,313,437
Fire Insurance Companies
' Ordinance 1948 429
Kahf 17-18
Insurance Act 1963,1996 429
Keynes, John Maynard 3, 168
Insurance Regulations 1966
Keynesian 147
430
Khalifah 29
Islamic Banking Act 1983 223,
Khiyar al-ru'ya 136
253,259-260, 263,271
Khiyar al-shart 136
Islamic Financial Services
Khrushchev, Nikita 13
Board Act 2002 497
Khyaral-'ayb 136
Life Assurance Act 1961 429
Kuwait Finance House 54-55, 78,
Life Assurance Companies
255, 270, 272,276,291, 301,
Ordinance 1948 427
304-305,307,316-317,320-323,
Offshore Insurance Act 1990
331,341, 343, 345, 347-349, 351,
434
488
Securities Commission Act 1993
414
L
Securities Industry Act 413
Labuan International Financial Takaful Act 433,435
Exchange 321, 406 Trust Act 1949 384
Labuan Offshore Financial Lembaga Tabung Haji 58-60,
Sen ices Authority 79,493 74
Laws 43. 221-224,227-228,240, Lenin, V. I 12-13
244-247, 249-250, 253-259,
Limited liability 363
261-262, 265-266, 271-272,274, Luxembourg Islamic Takaful
277-279,365 Company 432
Banking and Financial
Instituitions Act 1989 414 M
Capital Markets and Securities
Maad 29
Act 2007 418
Macroeconomics 3,37-38
Central Bank of Malaysia Act
Maisir 424-425,456
1958 390
Malaysia International Islamic
Companies Act 1965 223,
Financial Centre 79
259-260,362, 384, 413,
Malaysian Accounting Standards
501
Board 332,417
532 INDEX

Malaysian Global Sukuk 405-409, Munkarat 223

495 Muqaradah 131, 301,370-371
Malikis 130,133,135-136,204, 209 Murabahah 45-46,65, 69, 73, 129,
Management Risk Control 134-135, 141. 144-145, 149,158,
Committee 353 289, 293-294, 303-305,310,312,
Marufat 223 319,333-334,375,380,390-391,
Marx, Karl 72-13 394-395,397-399. 419, 467, 474,

Marxist 12 478,483-484.496

Masaqat 130,137,295,302,337 Musawamah 143,158

Maslow, Abraham 28 Muslim Commercial Bank 301
Master Agreement for Treasury Muslim Community Co-operative
Placement 496 Australia 46
Maximum profit 96.113,149,157 Muslim Community Credit Union
Maybank International 406 47
Mecca 43, 47-49,187,229 Muslim
Medina 47-48, 188-189, 229 countries 47. 51, 54. 56, 68. 73,
Microeconomics 3,37-38 86-87,94. 249.262,265,289,

Mit Ghamr Savings B.ink 44, 354,379,419, 433, 459-461,

52-53,58,60,63-65,86,353 464, 502-503
MNI Takaful Sdn Bhd 433 scholars 53,145-146,169,
Moral 9, II. 110, 182,222-223. 185-186,190, 201,204.
244,265 210-215,227,240,244,327,

obligation 158 363-366,368, 373,378-380

responsibility 111 Mustafa Kamal At-Taturk
Mozaraah 137, 291, 295,302, 70
337 Musyarakah 46,66, 69, 72,
Muamalat 51-52,151, 225 129-131,138,145, 149,155. 158,
Mudharabah 2,46, 49. 58-59, 66, 251, 289-290, 292-293,302-305.
69, 72, 83. 103,129-135, 143. 145, 310-311, 319.333, 335, 373,470
148-149, 151-152, 155-156, 158, Mutual funds 498
266, 289, 293, 297, 299,302-305, Muza'arah 130
309,317-319, 333, 335,337,339,
342,347, 349,363. 365,368-370, N
373,377-378, 382, 386-387.
Nasser Social Bank 55,63-65
392-394, 409-410, 440-444.
National Development Financing
448-450, 453,457
Institutions 468
 INDEX 533

National Shariah Advisory Profit-sharing 132,146, 149, 155,

Council on Islamic Banking 158,355,370,382,393-394,

and Takaful 76 449-450,473

Negotiable instruments of deposit Prophet Muhammad 2, 15,48-49,

392-393 86, 121, 124,153, 187-189,191,
New testament 178-181, 184 193-195,197,201,203,222,
Ningxia Islamic International 227-230.234-235, 237-240,
Trust and Investment 46 242-243,246-248, 278,432
Non-Marxist 12
Non-Muslim countries 45, 47, Q
353,499
Qard al-hasanah 302
Nubuwwah 29
Qard Hassan 46, 114-115, 129,
138-139,147-149,151,159,289,
O
291, 295,299-300.303-305, 319,
OIC See Organization of Islamic 324,327,368,388, 476

Conferences Qatar Global Sukuk 495

Old testament 172,174, 178-181, Qatar Islamic Bank 56, 145, 270,
184 331,351
Organization of blamic Qirad 49,131
Conferences 54, 61, 71,252, Qiyas 37-38,121, 222,227-228,
459, 462, 464,465 241, 243, 246, 248, 251,278
Information Systems Networks Quran 15,19,23-24,27-34,36-38,
487 44,97,117, 120-121,123,
Organization of Islamic Countries 125-126, 128-129, 149.158, 170,

435 186-187,190,192,199-203,211.

Oxven, Robert 11 214-215,222,224.226-233,

240-241,243-245,247-249, 251.

P 278,354, 379,439

Participation Term Certificates

R
371-373
Perbadanan N'asional Berhad 385 Rahn 129, 140, 159, 250,291, 295
Phillipine Amanah Bank 54 Reformists 183,185
Plato 10, 12,175-176 Regulations 43,221, 247, 253-254.
Products 116,288,308,354 256,258, 260, 263-264, 328,365,
Profit allocation 347 413,415,490
534 INDEX

Religious Supervisory Board Shafiis 130, 133,135-136, 203-204,

274-275 206

Renaissance JO Shamil Bank of Bahrain 298-299,

Revenue recognition 331-332, 301,304-305,307,315-317,

334 320-322,323,331-332, 341,

Riba 44, 49,51, 63-64,81-83, 95, 343-344,347,351

97, 101, 106, 117, 128,145, Shares 362-364, 367, 373,379-380,

157-158, 163-165, 168-169, 384

185-189,191- 195,197-198. Shu'ayb 15

204-205, 208-216. 245. 256, 267, Siti Khadijah 2
279, 285,359, 366-367,379,385, Smith, Adam 3-4, 9
418, 424-425, 456 Social Investment Bank,
classification 199-203 Bangladesh 110-111,325
Risk 62, 349-353,355,426-427, Social responsibility 109-110.139,
451-452,455, 502 158,323,354
Risk Management Framework Social Security Organisation 426
353 Social Security System 426
Risk-return sharing 145 SOCSO See Social Security
Romans 174-175,177 Organisation
Special purpose vehicle 402.
S 404-406
Stalin. Joseph 13
Saddadah-dhara'I 130
Standard Chartered Bank 406
Sail Dawala al-Hamadani 50-51
Stocks 362-368, 379, 419
Salam 143, 246, 293,374-375,
Sudanese Islamic Bank 69
378-379,419
Sukuk 341, 373-374, 382,406-408,
Sarf 144,290,293
419, 470, 496-498
Saudi-Philippine Islamic
Sunnah 28-29,36,227, 232-233,
Development Bank 55
239, 247,278,439
Securities Commission of
Surah 1,21-22.34, 116, 120-128.
Malaysia 79,252,352,364,366.
116, 127-128,13S, 152-154.156.
374, 379, 384,386-387, 395-398.
170,187, 190-192. 228-230,
400, 402-103, 412-415,418,420
232-233, 241-242, 245-247, 251
Services 58. 95, lie. 285-286, 288,
Syariah 35-39,44-46. 52-54,57,
291. 296-297, 300-314.349, 354,
59.63, 67-70, 72, 74-75, 77,81,
415-416,443,450-452,454,463.
83-84,87, 93, 98,101, 103-105,
471-472,484. 490,495. 498, 502
 INDEX 535

107-108, 121,129-130,134, Takaful IBB Berhad 433

136-138,145,147,149,151-153, Takaful Ikhlas 77,436,443, 446,
157-159, 169, 192, 205,221-228, 448,450-451,454
244, 246, 248-251, 255, 257-258, Takjiri 440-441
260-261, 267-269,271,276-279, Tauhid 29, 97
288-290, 293, 295-296, 298-299, Tawarruq 144
303, 305,320-321,325-329, 342, Theory of profit maximization 31,
348,352-354,363-365,367-368, 113

371,373-381, 383,385-386,392, Turkiye Finans 291,295,301

397, 418-419,424,433,435,
440-441, 456, 463-466, 479, U
484-485,487-488,491-496, 499,
Ujr 144,150,159,291,294,313,442
502
Ulama IS, 51-52,81, 86,169, 214,
Syariah Advisory Council 252,
363,375,419, 437,456
366-367,379,397,417
Unit trust funds 384-386
Syariah Supervisor}' Board 255,
United Bank 255
269-271,273,275-277, 279, 328,
Urbun 144
347-348, 490
Usury 165-168,170-172,179-180,
Syariah Supervisory Committee
182-183,186,188,190,194,
269,271
196-197,211, 215, 246, 256, 259,
Syariah Supervisory Council 141,
266.291, 302
364
Uthamaniyah empire 47,50
Syarikat Takaful Indonesia 433
Utopic socialism 11
Syarikat Takaful Malaysia
433-434,436, 443,445-450,
V
452-454,456-457
Vices See Munkarat
T Virtues See Marufat

Tabarru 440, 442-443,448-449,

W
451, 454, 457

Tadamon Islamic Bank 55,69, Wadiah 103, 129, 139-140, 147-148,

271,329 151.159.291, 295, 297,299-301,
Takaful 77. 79.417,423, 431-457, 310-311, 313,318,377-378

491,498,501 Wakalah 144, 150,159, 251,291,

Takaful Bank Pembangunan Islam 294,310,383, 386,440-444, 449,
433 457
 FINANCE AND
BANKING SYSTEM
Philosophies, Principles b Practices

THE AUTHORS...
Sudin Haron is a renowned scholar in business and management, as well as in banking and finance. Currently
he is the President of Kuala Lumpur Business School and Executive Chairman ofVision Bridge Sdn. Bhd. He was
attached with the Central Bank of Malaysia as a Specialist at the Islamic Banking and takaful department from
2005 to 2008. In 2008, he was appointed Deputy Chief Executive of International Centre for Education in
Islamic finance (INCEIF). Sudin had also served the Northern University of Malaysia in various capacities as an
academician and administrator. Prior to becoming an academician, he worked with one of the local banks m
Malaysia. Sudin has published extensively in the areas of Islamic and conventional banking, small business
and entrepreneurship, general management and marketing.

Wan Nursofiza Wan Azmi holds a PhD in Corporate Finance from the University of New England, Australia
She obtained her Master of Science in Corporate finance and Bachelor of Science in Business Economics from
the University of Salford. UK. Wan Nwsofiza was previously attached with INCEIF as a Research Fellow. Prior to
joining INCEIF, she was a lecturer at the Faculty of Finance and Banking, Northern University of Malaysia
Presently, she is the Director of Academic and Research of Kuala Lumpur Business School. Wan Nursofaa has
been involved in consultancy works and has published in many referred journals.

THE BOOK...
This book, Islamic Finance and Banking System: Philosophies, Principles & Practices, introduces readers to
the history and development of Islamic banking. It provides an in-depth discussion on the theoretical and
conceptual aspects of Islamic banking Key concepts in Islamic finance and banking, and how they are
applied to provide alternative Islamic financing options, are examined. The vibrant and thriving takaful
industry and Islamic capital market are also explored here. In addition, the book evaluates the role and
development of special organizations related to the Islamic financial system.